Chapter 4- Saving, Investment, and the Financial System

Financial Markets-The Bond Market

What is a Bond?

- A bond is essentially an IOU, a certificate of indebtedness that outlines the borrower's

obligations to the bond's buyer.

- It represents a loan made by an investor to a borrower (typically corporate or

governmental).

- The bond details include the repayment date (maturity date) and the interest rate that will
be paid periodically until the loan matures.

- Bonds can be held until maturity or sold earlier in the secondary market.

Why Issue Bonds?

- Corporations, governments, and municipal entities issue bonds to raise funds for various
projects like building new facilities, purchasing equipment, or infrastructural developments.

- Bonds are a direct way for these entities to borrow from the public without going through a
bank.
Characteristics of Bonds

Term: The duration until the bond matures, affecting the interest rate. Short-term bonds are
less risky than long-term bonds.

Credit Risk: The likelihood that the borrower will default on the interest or principal
payments. Bonds with a higher risk of default offer higher interest rates. Credit rating
agencies assess and rate bonds to help investors gauge this risk.
Tax Treatment: The interest earned on bonds can be taxable or tax-exempt, depending on
the issuer. Municipal bonds, for instance, are often exempt from federal income tax, which is
reflected in their lower interest rates compared to taxable bonds.
Inflation Protection: Some bonds, like Treasury Inflation-Protected Securities (TIPS) in the
U.S., adjust their interest and principal payments according to inflation rates, protecting
investors from purchasing power erosion due to inflation.

Importance in the Economy

- Bonds are a critical component of the financial system, offering a mechanism for long-term
financing for public and private projects.
- They also provide investors with a relatively safer investment option, compared to stocks,
with fixed income over a period.
Financial Markets-Stock Market
Financial System: The group of institutions in the economy that help to match one person’s
saving with another person’s investment.
Financial Markets: Financial institutions through which savers can directly provide funds to
borrowers.
Bond: A certificate of indebtedness.
- Equity Finance: Companies can issue shares of stock, representing ownership in the
company, to raise funds. This is known as equity finance.

- Ownership vs. Debt: Shareholders become part owners and share in the company's profits,
whereas bondholders are creditors who receive fixed interest payments.

- Stock Exchanges: Shares trade on stock exchanges where prices fluctuate based on supply
and demand, reflecting investor perceptions of the company's future profitability.

- Risk and Return: Stocks offer higher potential returns compared to bonds but come with
greater risk since shareholders are paid after bondholders in financial distress scenarios.

- Stock Indexes: Indexes track the performance of select company stocks to gauge overall
market health.
Financial Intermediaries-Banks
Financial Intermediaries: Financial institutions through which savers can indirectly provide funds
to borrowers.
Financing Small Businesses
- Small businesses, like a grocery store, often rely on bank loans for expansion, unlike large
companies such as Intel that can access funds via stock and bond markets. This is due to the
preference of most stock and bond buyers for larger, more established companies.
Banks as Financial Intermediaries:
- Collect deposits from savers, paying interest on these deposits.
- Use these deposits to make loans to borrowers, charging a higher interest rate.
- Profit from the difference between the interest paid to depositors and the interest received from
borrowers.
Facilitating Transactions:
- Enable the purchase of goods and services through checks and debit cards, providing a convenient
access to deposits.
- Serve as a medium of exchange, allowing for easy engagement in transactions, which is crucial for
daily economic activities.
Financial Intermediaries-Mutual Funds
Mutual Fund: An institution that sells shares to the public and uses the proceeds to buy a portfolio
of stocks and bonds.
Mutual Funds Overview
- Definition: Collects funds from the public to invest in diversified stock and bond portfolios.
Risk and Return: Investors bear portfolio performance risks and rewards.
Advantages
- Diversification: Allows investment in a wide range of assets, reducing risk.
- Professional Management: Offers expert stock selection aimed at maximizing returns.
Skepticism and Index Funds
Market Efficiency: Skepticism exists about consistently outperforming the market due to all
information being reflected in stock prices.
Index Funds: Often perform better than actively managed funds due to lower costs and minimal
trading, challenging the value of active management.

Financial Institutions Overview

Diversity: Includes bond and stock markets, banks, mutual funds, pension funds, credit
unions, insurance companies, and local loan sharks.
Common Purpose:
- All these institutions facilitate the flow of funds from savers to borrowers.
- Essential for efficient resource allocation and economic growth
1. Carly wants to buy and operate an ice-cream truck but doesn’t have the financial
resources to start the business. She borrows $20,000 from her friend Freddie, to whom
she promises an interest rate of 7 percent, and gets another $30,000 from her friend
Sam, to whom she promises a third of her profits. what best describes this situation?
a. Freddie is a stockholder, and Carly is a bondholder.
b. Freddie is a stockholder, and Sam is a bondholder.
c. Sam is a stockholder, and Carly is a bondholder.
d. Sam is a stockholder, and Freddie is a bondholder.
2. A bond tends to pay a high interest rate if it is ………………. .
a. a short-term bond rather than a long-term bond.
b. a municipal bond exempt from federal taxation.
c. issued by the federal government rather than a corporation.
d. issued by a corporation of dubious credit quality.
3. the main advantage of mutual funds is that they provide
a. a return insured by the government.
b. an easy way to hold a diversified portfolio.
c. an asset that is widely used as the medium of exchange.
d. a way to avoid fluctuations in stock and bond prices.

Saving and Investment in the National Income Accounts

Importance of Financial System
- Role: Coordinates saving and investment, crucial for economic growth and living
standards.
- Need for Understanding: Macroeconomists must grasp how financial markets function and
respond to events and policies.

National Income Accounts and Financial Markets

- Emphasis on Accounting: Focuses on defining and aggregating economic measures, akin to
personal accounting but for the economy.
- Key Variables: Include GDP and related statistics, essential for analyzing financial market
activities.
- Accounting Identities: Serve as foundational equations that demonstrate the relationships
between different economic variables, offering insights into the macroeconomic role of
financial markets.
National Saving (Saving): The total income in the economy that remains after paying for
consumption and government purchases.
Some Important Identities
GDP Components and Identities
- GDP (Y): Represents both total income and total expenditure on an economy's output,
divided into consumption (C), investment (I), government purchases (G), and net exports
(NX), simplified as Y = C + I + G + NX.
- Closed Economy Assumption: For simplification, assumes no international trade (NX =
0), hence Y = C + I + G.

National Saving
- Simplification for Closed Economy: Removing consumption and government purchases
from GDP gives Y - C - G = I, indicating that national saving (S) equals investment.
- S=I
- Definition of Saving (S): Total income left after paying for consumption and government
expenses, S = Y - C - G.
Y: Total income or output in the economy.

Components of National Saving

Private Saving: Income left after households pay taxes and consume, calculated as Y-T
- C.
S private = Y – T − C
T: Taxes paid by households.
Public Saving: Government's tax revenue left after spending, T - G, which can be a surplus
(if T > G) or a deficit (if G > T).
S public = T − G
 T: Tax revenue collected by the government from households and businesses.
G: Government spending on goods, services, and transfer payments.
- If tax revenue exceeds government spending (T > G), then public saving is positive,
indicating a budget surplus. This surplus can be used to pay down government debt, reduce
taxes, or increase government saving.
- On the other hand, if government spending exceeds tax revenue (G>T), then public
saving is negative, indicating a budget deficit. In this case, the government must borrow
funds to cover the shortfall, leading to an increase in government debt.

Role of Financial Markets

Equation S = I: Highlights that saving in the economy must equal investment, posing
questions about the mechanisms and coordination between savers and investors.

Financial System's Function: Acts as the intermediary, channelings national savings to

investment through various markets and institutions like bonds, stocks, banks, and mutual
funds.
The Meaning of Saving and Investment
Saving: Refers to income not used for consumption.

Investment: This means purchasing new capital, such as buildings or equipment.

S = I Identity: At the macro level, total saving equals total investment

Private Saving: The income that households have left after paying for taxes and
consumption.
Public Saving: The tax revenue that the government has left after paying for its spending.
Budget Surplus: An excess of tax revenue over government spending.
Budget Deficit: A shortfall of tax revenue from government spending

4. if the government collects more in tax revenue than it spends, and households
consume more than they get in after-tax income, then
a. private saving and public saving are both positive.
b. private saving and public saving are both negative.
c. private saving is positive, but public saving is negative.
d. private saving is negative, but public saving is positive.

5. A closed economy has income of $1,000, government spending of $200, taxes of $150,
and investment of $250. what is private saving?
a. $100
b. $200
c. $300
d. $400
The Market for Loanable Funds
Market For Loanable Funds: The market in which those who want to save supply funds
and those who want to borrow to invest demand funds.
Demand Curve: Slopes downward; higher interest rates decrease the quantity of loanable
funds demanded because borrowing becomes more expensive.
Supply Curve: Slopes upward; higher interest rates increase the quantity of loanable funds
supplied because saving becomes more attractive.

Equilibrium in the Market

Interest Rate Adjustment: The market reaches equilibrium when the supply of loanable funds
matches the demand, adjusting through changes in the interest rate.
- Example: At a 5% real interest rate, both the demand and supply of loanable funds equal
$1,200 billion.
Nominal Interest Rate: The reported rate, representing the monetary cost of borrowing or
return to saving.
Real Interest Rate: Adjusted for inflation, showing the true cost of borrowing or return to
saving. The market for loanable funds operates on the real interest rate.
 Policy 1: Saving Incentives
Economic Principle: A country's standard of living is tied to its production capabilities,
which in turn depend on capital accumulation fueled by savings.

Effects on the Market for Loanable Funds

- Supply Shift: Tax incentives for saving would increase the supply of loanable funds,
shifting the supply curve rightward.
- Interest Rate Impact: An increased supply of loanable funds would lead to lower interest
rates.
- Investment Growth: Lower interest rates would encourage more borrowing and, therefore,
more investment.
- Equilibrium Change: Results in a lower interest rate and higher quantity of loanable funds
demanded, fostering more investment.
6. if a popular TV show on personal finance convinces Americans to save more for
retirement, the _________ curve for loanable funds would shift, driving the equilibrium
interest rate _________.
a. supply; up
b. supply; down
c. demand; up
d. demand; down
7. if the business community becomes more optimistic about the profitability of capital,
the _________ curve for loanable funds would shift, driving the equilibrium interest
rate _________.
a. supply; up
b. supply; down
c. demand; up
d. demand; down
8. which of the following policy actions would unambiguously reduce the supply of
loanable funds and crowd out investment?
a. an increase in taxes and a decrease in government spending
b. a decrease in taxes together with an increase in government spending
c. an increase in both taxes and government spending
d. a decrease in both taxes and government spending
9. from 2008 to 2012, in the aftermath of the financial crisis, the ratio of government
debt to GDP in the United States
a. increased markedly.
b. decreased markedly.
c. was stable at a historically high level.
d. was stable at a historically low level.
1. For each of the following pairs, which bond would you expect to pay a higher interest
rate? Explain.

a. a bond of the U.S. government or a bond of an Eastern European government

- An Eastern European government bond would likely pay a higher interest rate than a U.S.
government bond due to perceived higher risks, such as political and economic instability.

b. a bond that repays the principal in the year 2020 or a bond that repays the principal in
the year 2040
- come with increased risks, such as inflation and changes in the economic environment so a
higher interest rate.

c. a bond from Coca-Cola or a bond from software the company you run in your garage - A
bond from a garage-run software company would pay a higher interest rate than one from
Coca-Cola. This is because the startup is considered riskier, lacking Coca-Cola's established
financial stability.

d. a bond issued by the federal government or a bond issued by New York State
- A bond issued by New York State would likely have a higher interest rate than a federal
government bond, as state bonds carry more risk due to the lack of monetary authority and
budget balancing requirements.

3. Explain the difference between saving and investment as defined by a

macroeconomist. Which of the following situations represent investment and which
represent saving? Explain.
a. Your family takes out a mortgage and buys a new house.
- This situation represents investment. Buying a new house is an investment, as a long-term
asset expected to generate value.
b. You use your $200 paycheck to buy stock in AT&T.
- This situation represents an investment. Buying stock in AT&T with your paycheck is
saving, or potential future gains.
c. Your roommate earns $100 and deposits it in his account at a bank.
- Depositing $100 in a bank account is saving because putting money for future use.
d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business.
- Borrowing $1,000 to buy a car for a pizza delivery business is an investment, it will be
used to generate income.
4-) Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5 trillion, and
public saving is $0.2 trillion. Assuming this economy is closed, calculate consumption,
government purchases, national savings, and investment.
a-) Consumption (C):
Consumption is equal to GDP minus private saving and public saving:
C = GDP - (S private + S public ) = 8 trillion−(0.5 trillion+0.2 trillion) = 7.3 trillion
b-) Government Purchases (G):
Government purchases can be calculated as the difference between GDP and consumption
and private saving:
G = GDP − C − Sprivate = 8 trillion − 7.3 trillion − 0.5 trillion 0.2 trillion
c-) National Savings (S):
National savings is the sum of private saving and public saving:
S national = S private + S public = 0.5 trillion+0.2 trillion = 0.7 trillion
d-) Investment (I):
In a closed economy, national saving equals investment:
I = S national = 0.7 trillion

5. Economists in Funlandia, a closed economy, have collected the following information

about the economy for a particular year:
Y = 10,000
C = 6,000
T = 1,500
G = 1,700
The economists also estimate that the investment function is:
I = 3,300 - 100r
where r is the country’s real interest rate, expressed as a percentage. Calculate private
savings, public savings, national savings, investment, and the equilibrium real interest
rate.
a-) Private Savings (Sprivate):
Private savings can be calculated as disposable income (Y - T) minus consumption (C):
Sprivate = Y – T – C =10,000−1,500−6,000 = 2,500
b-) Public Savings (Spublic):
Public savings can be calculated as government revenue (T) minus government spending
(G):
Spublic = T – G = 1,500 − 1,700 = −200
c-) National Savings (S):
National savings is the sum of private savings and public savings:
S national = S private + S public = 2,500 – 200 = 2,300
d-) Investment (I): We're given the investment function:
I = 3,300 − 100r = r=10
e-) Equilibrium Real Interest Rate (r):
The equilibrium real interest rate is 10%.

7. Three students have each saved $1,000. Each has an investment opportunity in which
he or she can invest up to $2,000. Here are the rates of return on the students’
investment projects:
Harry = 5 percent
Ron = 8 percent
Hermione = 20 percent
a. If borrowing and lending are prohibited, so each student can use only personal saving
to finance his or her own investment project, how much will each student have a year later
when the project pays its return?
Without borrowing and lending:
- Harry invests $1,000 at a 5% return: $1,000 * 1.05 = $1,050
- Ron invests $1,000 at an 8% return: $1,000 * 1.08 = $1,080
- Hermione invests $1,000 at a 20% return: $1,000 * 1.20 = $1,200
- So, Harry will have $1,050, Ron will have $1,080, and Hermione will have $1,200 a year
later.

b. Now suppose their school opens up a market for loanable funds in which students can
borrow and lend among themselves at an interest rate r. What would determine whether a
student would choose to be a borrower or lender in this market?
- A student would choose to borrow if the interest rate (r) is lower than the rate of return on
their investment project. They would choose to lend if the interest rate is higher than their
investment project's rate of return.
c. Among these three students, what would be the quantity of loanable funds supplied and
quantity demanded at an interest rate of 7 percent? At 10 percent?
Quantity supplied and demanded at different interest rates:

- At an interest rate of 7%, Harry and Ron would supply $1,000 each, and Hermione would
demand $2,000. So, the quantity supplied would be $2,000, and the quantity demanded
would be $2,000.

- At an interest rate of 10%, Harry and Ron would supply $1,000 each, and Hermione would
demand $2,000. So, the quantity supplied would be $2,000, and the quantity demanded
would be $2,000.
d. At what interest rate would the loanable funds market among these three students be in
equilibrium? At this interest rate, which student(s) would borrow and which student(s)
would lend?
- The equilibrium interest rate would be the rate at which the quantity supplied equals the
quantity demanded. From the previous part, this occurs at 7% or 10%.

e. At the equilibrium interest rate, how much does each student have a year later after the
investment projects pay their return and loans have been repaid? Compare your answers
to those you gave in part (a). Who benefits from the existence of the loanable funds
market—the borrowers or the lenders? Is anyone worse off?
At the equilibrium interest rate, each student would have:
- Harry: $1,050
- Ron: $1,080
- Hermione: $1,200
- Comparing with part (a), each student ends up with the same amount as before. However,
the existence of the loanable funds market allows Hermione to invest more and earn a higher
return, benefiting her. Borrowers benefit from access to funds to invest, while lenders earn
interest on their savings. No one is worse off if the market is competitive and efficient.
8. Suppose the government borrows $20 billion more next year than this year.
a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or
fall?
b. What happens to investment? To private saving? To public saving? To national saving?
Compare the size of the changes to the $20 billion of extra government borrowing.
c. How does the elasticity of supply of loanable funds affect the size of these changes?
d. How does the elasticity of demand for loanable funds affect the size of these changes?
e. Suppose households believe that greater government borrowing today implies higher
taxes to pay off the government debt in the future. What does this belief do to private saving
and the supply of loanable funds today? Does it increase or decrease the effects you
discussed in parts (a) and (b)?

a. Increased government borrowing of $20 billion shifts the demand curve for loanable funds
rightward, leading to a rise in the interest rate due to higher demand.

b. Consequences:

- Investment likely decreases because of the higher interest rates making borrowing more
expensive.
- Private Savings might increase as people are incentivized to save more with higher interest
rates.
- Public Saving decreases with more government borrowing, negatively impacting national
savings.
- National Saving decreases by the amount of extra government borrowing.
c. Elasticity of Supply of Loanable Funds:
- Inelastic supply leads to a significant increase in interest rates because the quantity of funds
can't easily expand.
- Elastic supply moderates the interest rate increase as the supply of funds adjusts more
readily.

d. Elasticity of Demand for Loanable Funds:

- Inelastic demand means investment decreases slightly with higher interest rates.
- Elastic demand results in a significant reduction in investment due to higher sensitivity to
interest rate changes.

e. Expectation of Future Taxes:

- If households expect higher future taxes due to increased borrowing, they might save more
now, increasing the supply of loanable funds.
- This could mitigate some of the rise in interest rates and decrease in investment but won't
fully negate the impact of increased government borrowing.
1. d 2. d 3. b 4. d 5. c 6. b 7. c 8. b 9. a