Savings and Investment

Dr. Katherine Sauer Principles of Macroeconomics ECO 2010
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Overview: I. II. III. IV. The Financial System Savings and Investment Policy US Deficit and Debt

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I. The Financial System is the group of institutions in an economy that help to match savings with investment

The US economy has two basic types of financial institutions: - financial markets - financial intermediaries 1. Financial Markets are institutions where funds are transferred directly from savers to investors.

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Examples: a. Bond Market A bond is a certificate of indebtedness. ³IOU´ When a firm issues bonds to raise money, it is called debt finance. When a firm (or government) issues a bond, they are promising to pay you back a certain value in the future. A bond has a date of maturity and a rate of interest associated with it.

Characteristics that determine a bond¶s value: - term: length of time until the bond matures - usually long term bonds pay a higher interest rate than short term bonds - credit risk: the probability that the borrower will fail to pay the interest or the principal - the riskier the bond, the higher the interest rate - tax treatment: some bond interest is tax free

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b. Stock Market A stock is a claim of partial ownership of a firm. When a firm issues stock to raise money, it is called equity finance. If you buy a stock, you are not guaranteed to get your money back. Stocks are sold in organized stock exchanges and the prices are determined by supply and demand. The price of a stock generally reflects the perception of a firm¶s future profitability.

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2. Financial Intermediaries are institutions where funds are transferred indirectly from savers to investors. Examples: a. Banks accept savings deposits and make loans. - pay interest to depositors, charge interest to borrowers

b. Mutual Funds are institutions that sell shares to the public and use the proceeds to buy a portfolio of stocks and bonds. - allows individuals with a small amount of money to diversify

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II. Savings and Investment Recall: Investment is important for economic growth S I K K/L productivity standard of living

savings = all production ± all consumption (closed economy) S = Y±C±G Y=C+I+G Y±C±G=I S = I
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Let¶s define National Saving (S) as Y ± C ± G. aka Total Saving Let¶s add taxes to this model. (how could we have G without T?) S=Y±C±G+T±T S = (Y ± T ± C ) + (T ± G) Y ± T ± C = private savings T ± G = public savings (aka gov¶t savings) National Savings = Private Savings + Public Savings
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More on Public Savings: if T ± G > 0, there is a budget surplus if T ± G < 0, there is a budget deficit if T ± G = 0, then the budget is balanced

Recap: In a closed economy,

I = S = Sprivate + Spublic

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The Market for Loanable Funds The supply of funds comes from savings. The demand for funds comes from investment. The ³price´ of funds is the real interest rate. r SF (Savings) The supply of funds slopes up because as r rises, people will save a higher quantity. The demand for funds slopes down because as r rises, firms will borrow a lower quantity.
DF (Investment) Quantity of Funds Level of S Level of I

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r

SF (Savings)

The equilibrium occurs where the supply of funds equals the demand for funds. If r > r*, the supply would exceed the demand and there would be a surplus, pushing the interest rate down.

r*

Q*

If r < r*, the demand would exceed the supply and there DF (Investment) would be a shortage, Quantity of Funds pushing the interest rate up.
Level of S Level of I
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The supply curve will shift when total savings changes. - public savings or private savings The demand curve will shift when investment changes.

III. Policy Since investment is good for economic growth, a government may want to pursue policies that encourage it. Some government actions result in a decrease in investment. 3 policies - savings incentives - investment incentives - budget deficits

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1. Savings Incentives The government can encourage investment indirectly by way of encouraging savings.

Ways to encourage savings: - discourage consumption (e.g. sales tax) - all interest earned to be tax exempt

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Ex: Consumption Tax

r

SF SF2

1) The tax on consumption would make people buy less and therefore save more. - private savings rises 2) Supply of funds shifts right 3) r falls 4) Q rises level of S rises level of I rises

r1 r2

DF Q1 Q2 Quantity of Funds Level of S Level of I

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2. Investment Incentives The government can directly encourage investment. Ex: investment tax credit

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Ex: Tax credit for expanding size of plant
r SF

1) The tax credit would encourage some firms to expand their size - investment rises 2) Demand for funds shifts right 3) r rises 4) Q rises level of S rises level of I rises

r2 r1

DF2 DF Q1 Q2

Quantity of Funds Level of S Level of I

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Comparison of policies 1 and 2: Both result in higher levels of Investment. Encouraging savings results in a lower interest rate. Encouraging investment results in a higher interest rate. Which policy might be better for sustaining long run economic growth?

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3. Government Budget Deficits Because government savings is a component of National Savings, budget deficits and surpluses affect the market for loanable funds. T > G budget surplus, public savings increasing T < G budget deficit, public savings decreasing

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Suppose the government starts running a larger budget deficit.
r SF2 SF

1) When the government runs a deficit, public savings falls 2) Supply of funds shifts left 3) r rises 4) Q falls level of S falls level of I falls

r2 r1

DF Q2 Q1 Quantity of Funds Level of S Level of I

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This sequence of events is known as crowding out. - a decrease in investment that results from government borrowing

When the government runs a deficit, it issues bonds to borrow money from the public.

Issue price: $18.75 Maturity date: May 2008 Interest over 30 years: $87.92 Final value: $106.67 Treasurydirect.gov
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IV. US Government Deficit and Debt

from the CBO

Nominal numbers!

The deficit figure that gets reported in the news is $-1,413.6 billion. Revenues ± Outlays = deficit 2,104.6 ± 3,518.2 = - 1,413.6 This is misleading! Because Social Security currently takes in more than it spends, the government ³borrows´ it for current spending. The deficit would look larger if this weren¶t happening. Revenues are really 137 less: 137.3 - 0.3 = 137 (-1,413.6) + (- 137) = - 1,550.6
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Sometimes people say that there were large budget surpluses during the Clinton years and that Bush lost them. - misleading! There was only a true budget surplus in 1999 and 2000.

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In 2009: government revenues were the equivalent of 14.8% of GDP government spending was the equivalent of 24.7% of GDP The deficit was the equivalent of -10.9% of GDP The public debt was the equivalent of 53% of GDP - actual debt is higher

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From the CBO: Projected Outlays and Revenues as % of GDP

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From the CBO: Deficit or Surplus as % of GDP

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Debt to GDP Percentage In Hands of Public start end 88.3 84.3 84.3 61.6 61.6 52.0 52.0 45.6 45.6 40.0 40.0 33.3 33.3 27.4 27.4 27.5 27.5 26.1 26.1 34.0 34.0 41.0 41.0 48.1 48.1 48.4 48.4 34.7 34.7 36.8 36.8 40.2 Gross Debt start end 97.6 98.2 98.2 74.3 74.3 63.9 63.9 56.0 56.0 49.3 49.3 42.5 42.5 37.1 37.1 36.2 36.2 33.4 33.4 40.7 40.7 51.9 51.9 64.1 64.1 67.1 67.1 57.3 57.3 62.9 62.9 69.2
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U.S. President Roosevelt/Truman Truman Eisenhower Eisenhower Kennedy/Johnson Johnson Nixon Ford Carter Reagan Reagan George H. W. Bush Clinton Clinton George W. Bush George W. Bush

Party Term Years D 1945-1949 D 1949-1953 R 1953-1957 R 1957-1961 D 1961-1965 D 1965-1969 R 1969-1973 R 1973-1977 D 1977-1981 R 1981-1985 R 1985-1989 R 1989-1993 D 1993-1997 D 1997-2001 R 2001-2005 R 2005-2009

Table 7.1 from http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf

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