Saving, Investment,

and the Financial

System

Chapter 26

Copyright © 2001 by Harcourt, Inc.

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 The Financial System

 The financial system consists of

institutions that help to match one
person’s saving with another person’s
investment.
 It moves the economy’s scarce resources
from savers to borrowers.
 The financial system is made up of
institutions(Markets and Intermediaries)

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 Financial Institutions
in the U.S. Economy

 Financial Markets
 StockMarket
 Bond Market

 Financial Intermediaries
 Banks

 Mutual Funds

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 Other Financial Institutions

 Creditunions
 Pension funds

 Insurance companies

 Loan sharks

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 The Bond Market

A bond is a certificate
of indebtedness that
specifies obligations of
the borrower to the
holder of the bond.

IOU

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 Characteristics of a Bond

 Term: The length of time until the bond

matures.
 Credit Risk: The probability that the
borrower will fail to pay some of the
interest or principal.
 Tax Treatment: The way in which the
tax laws treat the interest on the bond.
 Municipal bonds are federal tax exempt.

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 Stock Market Basics
 What is Stock?
A stock is a
tradable security
that a firm issues to
certify that the
stockholder owns a
share of the firm.
Figure 19.1 shows
an example of a
stock certificate.

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 The Stock Market

 Stock represents ownership in a firm and

is therefore, a claim to the profits that the
firm makes.
 The sale of stock to raise money is called
equity financing.
 Compared to bonds, stocks offer both higher
risk and potentially higher returns.

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 The Stock Market

The most important stock exchanges in

the United States are the New York
Stock Exchange, the American Stock
Exchange, and NASDAQ.

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 The Stock Market

Most newspaper stock tables provide the

following information:
 Price (of a share)

 Volume (number of shares sold)

 Dividend (profits paid to stockholders)

 Price-earnings ratio

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 Stock Market Basics

 Reading the Stock Market Report

 Figure 19.2 in the textbook shows a part of a page
from of the Wall Street Journal.

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 The Market for Loanable Funds

Loanable funds refers to all income

that people have chosen to save and
lend out, rather than use for their
own consumption.

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 Market for Loanable Funds...
Interest
Rate
Supply

5%

Demand

0 $1,200 Loanable Funds (in

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billions of dollars)
 Government Policies That Affect
Saving and Investment

 Taxes and saving

 Taxes and investment

 Government budget deficits

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An Increase in the Supply of Loanable

Funds...
Interest Supply, S1 S2
Rate

5% 1. Tax incentives for

saving increase the
supply of loanable
4% funds...

2. ...which Demand
reduces the
equilibrium
interest rate...
0 $1,200 $1,600 Loanable Funds
(in billions of dollars)
3. ...and raises the equilibrium quantity of loanable funds.
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An Increase in the Demand for

Loanable Funds...
Interest
Rate Supply
1. An investment tax
6% credit increases the
demand for loanable
5% funds...

2. ...which
raises the D2
equilibrium
interest rate... Demand, D1

0 $1,200 $1,400 Loanable Funds

3. ...and raises the equilibrium (in billions of dollars)
quantity of loanable funds.
 Government Budget Deficits and
Surpluses

 When the government spends more than it

receives in tax revenues, the short fall is called
the budget deficit.
 For 2003, the budget deficit is $307 billion
 The accumulation of past budget deficits is
called the government debt.
 For 2003, the total debt is 6.7 trillion.

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 Government Budget Deficits and
Surpluses
 Government borrowing to finance its
budget deficit reduces the supply of
loanable funds available to finance
investment by households and firms.
 This fall in investment is referred to as
crowding out.
 The deficit borrowing crowds out private
borrowers who are trying to finance
investments.
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The Effect of a Government Budget

Deficit...
Interest S2
Rate Supply, S1

6% 1. A budget deficit
decreases the
supply of loanable
5% funds...

2. ...which
raises the
equilibrium Demand
interest rate...

0 $800 $1,200 Loanable Funds

3. ...and reduces the equilibrium (in billions of dollars)
quantity of loanable funds.