The Financial System: Institutions, Saving, and Investment

The Financial System

Introduction to the Financial System

The financial system is a network of institutions that helps match the saving of one person with the investment of another. It plays a crucial role in channeling funds from savers to borrowers, thereby facilitating economic growth and development.

• Financial markets: Institutions through which savers can directly provide funds to borrowers.

• Examples: The Bond Market, The Stock Market

Financial Markets

The Bond Market

A bond is a certificate of indebtedness, representing a loan made by an investor to a borrower (typically corporate or governmental).

• Date of maturity: The date when the loan will be repaid.

• Yield: The interest rate paid to the bondholder.

• Principal: The amount originally borrowed.

Bonds differ according to three key characteristics:

• Term: The length of time until the bond matures (e.g., perpetuity, which never matures).

• Credit risk: The probability that the borrower will default on payments.

• Tax treatment: How tax laws view interest income (e.g., municipal bonds may be tax-exempt).

The Stock Market

A stock is a claim to partial ownership in a firm, entitling the owner to a share of the firm's profits.

• Equity finance: Raising capital by selling stock.

• Debt finance: Raising capital by selling bonds.

• Stocks generally offer higher risk and potentially higher average returns compared to bonds.

• After an Initial Public Offering (IPO), shares are traded on organized stock exchanges (e.g., NYSE, NASDAQ).

Reading Stock Tables

When tracking stock performance, pay close attention to:

• Price: Cost of a single share.

• Dividend: Share of profits paid out to stockholders.

• P/E Ratio: Share price divided by earnings per share.

Stock tables are available online (e.g., Bloomberg).

Financial Institutions

Financial Intermediaries

Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers.

• Commercial banks: Accept deposits and make loans; create a medium of exchange (money).

• Mutual funds: Sell shares to the public and use the proceeds to buy a diversified portfolio of stocks and bonds.

Advantages of intermediation:

• Banks reduce search and monitoring costs for savers and borrowers.

• Mutual funds allow savers to diversify their investments, reducing risk.

Saving in the Economy

Different Kinds of Saving

• Private saving: The portion of households’ income that is not used for consumption or paying taxes.

  • Formula: $Y - T - C$

• Public saving: Tax revenue less government spending.

  • Formula: $T - G$

Budget Deficits and Surpluses

• Budget surplus: An excess of tax revenue over government spending.

  • Formula: $T - G$ (equals public saving)

• Budget deficit: A shortfall of tax revenue from government spending.

  • Formula: $G - T$ (equals negative public saving)

National

Saving

National saving is the sum of private and public saving. It represents the portion of national income that is not used for consumption or government purchases.

• Formula: $\text{National Saving} = (Y - T - C) + (T - G) = Y - C - G$

Saving and Investment in the Macroeconomy

National Income Accounting Identity

The basic identity for a closed economy (no net exports) is:

• $Y = C + I + G$

• Solving for investment: $I = Y - C - G = \text{National Saving}$

Thus, in a closed economy, saving equals investment.

The Meaning of Saving and Investment

• Private saving: Income remaining after households pay taxes and consume goods/services. Used for buying bonds, stocks, mutual funds, or held in bank accounts.

• Investment: The purchase of new capital (e.g., factories, equipment, new houses). Note: In economics, investment does not refer to buying stocks and bonds.

Examples of investment:

• A company builds a new factory.

• An individual buys equipment for a business.

• A family has a new house built.

The Market for Loanable Funds

Overview of the Loanable Funds Market

The market for loanable funds is a supply-demand model that helps us understand how the financial system coordinates saving and investment, and how government policies affect interest rates.

• Assume a single financial market where all savers deposit funds and all borrowers take out loans.

• There is one interest rate, which is both the return to saving and the cost of borrowing.

Supply and Demand in the Loanable Funds Market

• Supply of loanable funds: Comes from saving (households and public saving). If public saving is positive, it adds to supply; if negative, it reduces supply.

• Demand for loanable funds: Comes from investment (firms and households borrowing to finance new capital).

The Supply Curve

• An increase in the interest rate makes saving more attractive, increasing the quantity of loanable funds supplied.

The Demand Curve

• A fall in the interest rate reduces the cost of borrowing, increasing the quantity of loanable funds demanded.

Equilibrium

• The interest rate adjusts to equate supply and demand for loanable funds.

• The equilibrium quantity of loanable funds equals equilibrium investment and saving.

Government Policies and the Loanable Funds Market

• Policy 1: Saving Incentives

  • Tax incentives for saving increase the supply of loanable funds, reduce the equilibrium interest rate, and increase the equilibrium quantity of funds.

• Policy 2: Investment Incentives

  • Investment tax credits increase the demand for loanable funds, raise the equilibrium interest rate, and increase the equilibrium quantity of funds.

• Policy 3: Government Budget Deficits

  • A budget deficit reduces national saving and the supply of loanable funds, increasing the equilibrium interest rate and decreasing the equilibrium quantity of funds.

Budget Deficits, Crowding Out, and Long-Run Growth

• When the government borrows to finance a deficit, less funds are available for investment. This is called crowding out.

• Investment is important for long-run economic growth; thus, budget deficits can reduce the economy's growth rate and future standard of living.