Savings, Investment and Financial System

Definition
- Physical capital: tools, instruments, machines, buildings – produced in the past and
used today for goods and services
- Financial capital: funds that firms use to buy and operate physical capital
- Gross investment: total amount spent on new capital goods
- Net investment: change in quantity of capital
à gross investment – depreciation
- Wealth: value of all the things that a person owns
- Savings: amount of income that is not paid in taxes or spend on consumption goods
o Adds to wealth
Financial Institutions and Markets
- Markets for financial capital (saving is the source of funds that are used to finance
investments)
o Loans market
 Short-term loans to buy inventories or extend credit to their
customers (bank loan)
 Funds to purchase big ticket items (auto, house furnishing and
appliance) à credit cards
o Bond market
 Bonds issued by firms and government that are traded
 Loan made by an investor to a borrower (firm or government)
 Mortgage-backed security which entitles the holder to the income
from a package of mortgage
o Stock market
 Shares of companies’ stocks are traded
 Preferred stock à no voting
- Financial markets
o Financial institution that operates on both sides of the markets
 Investment banks
 Commercial banks
 Government sponsored mortgage lenders
 Pension funds
 Insurance companies
Financial institutions
- Insolvency
o Net worth: total market value of what a FI has lent
à equity = total assets – total outside liabilities of company
Net worth > 0 FI is solvent and remains in business
Net worth < = FI is insolvent and must stop its activities
o Stockholders of an insolvent financial institution bear the loss when the assets
are sold, and debts are paid
- illiquidity
o It is illiquid if it has made long-term loans with borrowed funds and is faced
with a sudden demand to repay more of what it has borrowed than its
available cash
o A FI that is illiquid can borrow from another institution
 o If al FIs are short of cash, the market for loans among financial institution
dries up à credit crunch
Financial markets
- Interest Rates
o Stock, bond, loans are collectively called financial assets
o Interest rate on a financial asset: percentage of price of the asset
 Asset price rise, c.p. the interest rate falls
 Asset price falls, interest rate rises
- Yield curve
o Government is least risky borrower and pays the lowest interest rate
o Riskiest firms (Ccc) pay higher interest rate than the safest (Aaa)

Market for Loanable funds

- Aggregate of the market for loans, bonds and stocks
- There is just one average interest rate which we refer to as the interest rate
Flows in the market for loanable funds
Used for (demand)
1. Business investment
2. Government budget deficit
3. International investment or lending
Come from (supply)
1. Private saving
2. Government budget surplus
3. International borrowing
Demand
- total quantity of funds demanded to finance investment the government budget
deficit and international investment or lending during a given period of time
- investment: major item that influence the demand
o the real interest rates
 r = (1+R)/(1+i)
 opportunity cost of the funds used to finance the purchase of capital
 firms compare real interest rate with rate of profit
 firms invest only when rate of profit > r
the higher the real interest rate, the fewer projects that are profitable so
the lower is the quantity of loanable funds demanded
 the lower the real interest rate, the more projects that are profitable so
the larger is the quantity of loanable funds demanded
o expected profit
 change in expected profit à DLFs change
the greater the expected profit from new capital the greater the
amount of investment and the greater the DLF, ceteris paribus.
 Influence can be placed in
 Objective influence: phase of the BC, technological change and
population growth
 Subjective influence: (optimism/pessimism) “animal spirits” by
Keynes or “irrational exuberance” by Greenspan

Supply
- Total funds available for private saving, the government budget surplus and
international borrowing during a given period of time
- Depends on
o Real interest rate
 Opportunity cost of consumption expenditure
 A dollar spent is. Dollar not saved, interest is forgone
The higher the real interest rate, the greater the quantity of saving
and the greater the quantity of loanable funds supplied, ceteris
paribus
o Disposable income
 Income earned – net taxes
The greater a household DI, the greater its saving
o Wealth
 The greater a household’s wealth, the less it will save
o Expected future income
 The higher the expected future income, the smaller its saving today
o Default risk
  The greater the default risk, the smaller is the supply of loanable
funds.

Equilibrium

If r = 8%
à demand < supply
à surplus on funds
à real interest rate falls

If r= 4%
à demand > supply
à shortage of funds
à interest rate rises

If r=6%
à demand = supply
Neither a shortage nor surplus
Real interest rate is at its equilibrium

Global Financial Crisis

- Events in the market for loanable funds on both sides (supply and demand)
- Increase in default risk decrease the supply of loanable funds
- The disappearance of major institutions and lowered profit expectation decreased
demand for LF
- Interest rate were low (2002-2005). Plenty of willing borrowers and lenders
- Easy loans à home price rose rapidly
- Mortgage-backed securities
- 2008 interest rise and home prices fell
- People defaulted on mortgages and banks took losses (became insolvent)
Government in LFM
- Budget surplus increase the supply of loanable funds
o Supply of LF = government budget surplus + private savings
o Increase brings lower real interest rate, decrease in private funds supplied
and increase in quantity of investment and of LF demanded
- Budget deficit increases the demand of loanable funds
o Increase raises real interest rate, increase of private funds supplied
The higher the interest rate, decrease investment and the quantity of
loanable funds demanded by firms
- Crowding-out effect: tendency for. Government budget deficit to raise the real
interest rate and decrease investment
o Ricardo barro effect
 Proposition that government budget deficit has no effect on the real
interest rate or investment
 Private savings and private supply of LF increase to offset any
government budget deficit
 Supply of LF increases by an amount = to the government budget
deficit and the interest rate does not change
 Most unlikely outcome

Low interest rate

Demand for LF decreased after Financial crisis
- Rescue plan
o Increase its demand for LF but total continue to decrease
o Fed increased SLF
o Increase in supply limited the decrease in investment and the severe of the
recession