Chapter 13 Financial Markets Saving Investment

chapter
Financial Markets,
13 Saving,
and Investment
©2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
13.1 Financial Institutions
and Intermediaries
• Investments are necessary for

economic growth.
• Firms invest in new capital
(machines and factories) to make
labor more productive.
• Financial institutions facilitate
the channeling of saving into
investment.
• The financial system is composed of
both financial markets and financial
intermediaries.
• The loanable funds market is where
households make their saving
available to those who desire to
borrow additional funds.
• Savings can be kept in a in a bank,
or used to buy stocks or bonds, or
other financial assets, such as
treasury bills or mutual funds.
• We begin by discussing two of the
most important financial markets—
the bond market and the stock
market.
Bonds
• Bond is an obligation issued by the
corporation that promises the holder to
receive fixed annual interest payments
and payment of the principal upon
maturity.
• Bondholders have greater financial
security than stockholders, but receive
a fixed annual interest payment.
• However, there are some risks involved
with holding bonds, such as from
corporate bankruptcy or higher market
interest rates.
Stocks
• The owners of corporations own

shares of stock in the company
and are called stockholders.
• Individuals and institutions buy
shares of stock in the stock
market (e.g., NYSE).
• The price of stocks fluctuate
(often many times a day) with
changes in demand or supply.
• The two primary types of stock are
preferred stock and common stock.
• Preferred stock is a stock that
pays fixed, regular dividend
payments despite the profits of
the corporation.
• Common stock is residual claimants
of corporate resources who receive
a proportion of profits based upon
the ratio of shares held.
Retained Earnings
• A company can raise money by

issuing bonds, new stocks, or
through retained earnings.
• Retained earnings is the practice
of using corporate profits for
capital investment rather than
dividend payouts.
The Value of Securities
• The two most important financial

markets where savers can provide
funds to borrowers are the stock
market and the bond market.
• Securities refer to stocks and bonds.
• The values of securities sold in
financial markets change with
expectations of benefits and costs.
• Optimistic expectations will raise
their value and pessimistic
expectations will lower them.
• Economists have a theory about
the stock market. They call it a
random walk. That is, it is
difficult, without illegal inside
information or a lot of luck, to
consistently pick winners in the
stock market.
Reading Stock Tables
• Below is a reproduction of the Wall
Street Journal on November 12, 2009.
• Let’s look at the key indicators for
one stock— Harley-Davidson—a company
that makes motorcycles and
accessories.
• The first two columns show the
stock’s performance over the last 52
weeks—the highest price in the first
column and the lowest price in the
second column.
• Harley-Davidson has been as high as
$29.08 per share and as low as
$7.99.
• In column three we see the name of
the stock—Harley-Davidson; the
symbol for this stock is HOG.
• Also in column three is the dividend
—this number indicates the annual
amount the company has paid over the
preceding year on each share of
stock ($0.40 per share here).
• If we divide the dividend by the
price of the stock, we get the
figure in the fourth column
called the yield—1.5 percent.
• The fifth column has the price-
earnings ratio (PE), found by
taking the price of the stock and
dividing it by the amount the
company earned per share over the
past year.
• The price-earnings ratio is a measure
of how highly a stock is valued. A
typical price-earnings ratio is about
15; Harley-Davidson’s PE is 25.
• The last three columns measure the
performance of the stock on the last
trading day—the stock’s volume for
the day, closing price, and net
change from the closing price of the
previous day.
52 weeks YLD VOL NET
HI LO STOCK (DIV) % PE 100S CLOSE CHG
29.08 7.99 HarleyDav .4 1.5 25 20,825 26.25 -0.59
Reading a Stock Table
Financial Intermediaries
• Financial intermediaries are

financial institutions that
accept funds from savers and make
them available to borrowers.
• A bank is a financial
intermediary that takes in
deposits from customers who want
to save and makes loans available
to those who want to borrow.
• Another important financial
intermediary is mutual funds.
Mutual fund companies sell
portfolio of stocks and bonds.
• The advantage of a mutual fund it
is allows an individual with even
a small amount of income to
spread risk across hundreds of
different companies.
• Another financial intermediary is
savings and loans. They accept
deposits in savings accounts and
pay interest for these funds.
• The most important purpose of
these institutions is to make
mortgage loans on residential
property.
• Another financial intermediary,
insurance companies, will invest
your premiums in financial
markets.
• They can make a profit if their
investment income is greater than
their losses on insurance claims.
13.2 Saving, Investment,
and the Financial System
• Saving and investment are
critical components of long-run
economic growth and living
standards.
• Let us see how we can use
national income accounting to
understand the relationship
between total saving and total
investment.
The Macroeconomics of
Saving and Investment
• For the economy as a whole, total

saving must equal total
investment.
S=I
• Savings can be private or public.
Sprivate = Y - C - T + TR
Spublic = T - G -TR
• Thus,
S = Sprivate + Spublic
The Market for Loanable Funds
• Investments make the economy to grow
and increases in real incomes and
living standards.
• Well functioning financial markets
channel funds from savers to
investors.
• For simplicity, let us assume the
loanable funds market is a single big
financial market where all savers
deposit their saving there and all
borrowers go there to take out loans.
• In this market, there is one
interest rate, which represents
both the cost to borrow
• and the return to saving.
• In the market for loanable funds,
the market interest rate and the
quantity of loanable funds is
determined by the interaction of
borrowers and lenders.
The Demand for Loanable Funds
• Both, firms and households borrow in
the loanable funds market to make
investments. Households in new houses
or cars etc., and firms in new capital
equipments.
• The demand for loanable funds curve is
negatively sloped. A higher interest
rate makes it more expensive to borrow,
so the quantity of loanable funds
demanded falls; a lower interest rate
makes it less expensive to borrow, so
the quantity of loanable funds demanded
rises.
The Supply of Loanable Funds
• Households make their saving

available to those who need to
borrow funds in the loanable
funds market in exchange for
interest payments.
• The supply of loanable funds
curve is positively sloped. Thus,
the households are willing to
save and supply loanable funds at
higher interest rates, and less
at lower interest rates.
The Equilibrium Adjusts to Balance
the
Demand and Supply of Loanable
•Funds
The interest rate adjusts to
generate equilibrium in the
loanable funds market.
• In equilibrium, the quantity of
loanable funds demanded is equal
to the quantity of loanable funds
supplied at the equilibrium real
interest rate, r*, as seen in
Exhibit 1.
The Market for Loanable Funds
Analyzing the Market for
Loanable Funds
• Saving is an important long-run
determinant of real economic
growth and the standard of
living.
• Thus, policymakers may want to
create saving incentives by
changing the tax code—perhaps
making Individual Retirement
Accounts (IRAs) more attractive.
• This would encourage people to
save more of their income, because
it would not be taxed.
• The new law would shift the
loanable funds supply curve to the
right, from S1 to S2, leading to a
lower equilibrium real interest
rate and a higher equilibrium
quantity of loanable funds
exchanged—as seen in Exhibit 2.
Saving Incentives or a Consumption Tax
• A consumption tax is a tax on
spending rather than earnings. This
will lower spending and increase
savings.
• Consequently, the supply of loanable
funds curve will shift to the right
from S1 to S2 in Exhibit 2, which
lowers the interest rate from r1 to
r2 and leads to a great equilibrium
quantity of loanable funds—more
saving and investment.
• An investment tax credit, or
other investment incentive would
encourage businesses to invest
more and increase the demand for
loanable funds.
• Likewise, a technological change
may increase the profitability of
a new investment, increasing the
firms’ demand for loanable funds.
• An increase in the demand for
loanable funds increases the real
interest rate from r1 to r2, and
the equilibrium quantity of
loanable funds exchanged rises
from Q1 to Q2.
• Consequently the amount of saving
and investment increases.
An Investment Tax Credit or a Technological Change
• When the government runs a budget
deficit, public saving is negative,
lowering the supply of national
saving and shifting the loanable
funds supply curve leftward from S1
to S2.
• At the new equilibrium, the result
is a higher real interest rate and a
lower equilibrium quantity of
loanable funds that is, less saving
and investment.
• When the real interest rate rises
as a result of the government
budget deficit, it causes a
decrease in private investment,
known as the crowding-out effect.
Effects of a Government Budget Deficit
• When the government runs a budget
surplus, public saving is
positive, increasing national
saving and causing the saving
supply curve to shift rightward
from S1 to S2.
• This shift leads to a decrease in
the real interest rate to r2 and
an increase in equilibrium saving
and investment from Q1 to Q2.
• The budget surplus results in an
increase in the supply of
loanable funds, a lower real
interest rate, and larger amounts
of saving and investment. These
factors cause increases in the
capital formation and economic
growth.
Effects of a Government Budget Surplus
Interest Rates and the Inflow
and Outflow of Capital
• When the demand for loanable
funds is strong, the domestic
real interest rate is high and
capital inflows from foreign
countries increase the supply of
loanable funds, increasing the
funds available for capital
investment.
• When the demand for loanable funds is
weak, the domestic real interest rate
is low and capital flows out to
foreign countries, lowering the
supply of loanable funds and reducing
the funds available for investment.
That is, capital inflows encourage
capital formation and economic
growth, and capital outflows hinder
capital formation and reduce the rate
of economic growth.
Net Inflow and Outflow of Capital in the
Loanable Funds Market
13.3 The Financial Crisis of
2008
• The best word to sum up the
financial crisis of 2008 is DEBT. In
technical terms, it is called
excessive leverage.
• In short, too many homeowners and
financial firms had assumed too much
debt and taken on too much risk.
• Many economists believe the crisis
started in the housing market, with
declining housing prices, and risky
mortgages.
Low Interest Rates (2002–2004) Led
to
Aggressive Borrowing
• After the 2001 recession, the Fed
pursued an expansionary monetary
policy that pushed interest rates
down to historically low levels.
• The federal funds rate was
maintained at 2 percent or lower for
almost three Years.
• Critics of the Fed argue that it
lowered interest rates too much, for
too long, in a growing economy, as
shown in Exhibit 1.
Effective Federal Funds Rate (FEDFUNDS)
Deregulation in the Housing Market
and Subprime Mortgages
• In the last several decades the
federal government encouraged the
mortgage industry, especially Fannie
Mae and Freddy Mac, to lower lending
standards for low-income families in
an effort to increase home ownership.
• Fannie Mae and Freddy Mac are the
government sponsored enterprises that
fund or guarantee the majority of
mortgage loans in the United States.
• Lenders devised innovative adjustable
rate mortgages (ARM) with extremely
low “teaser” rates, making it
possible for many new higher risk
buyers to purchase houses, often with
little or no money as a down payment.
• These loans were called subprime
loans because the borrower had less
than a prime credit rating and many
would not have qualified for a
conventional loan.
• In 2006, almost 70 percent of the
subprime loans were in the form of a
new innovative product called a hybrid.
• These loans started at a very low fixed
rate for the initial period, say three
to seven years, and then reset to a
much higher rate for the remainder of
the loan.
• Many subprime borrowers just expected
to refinance later—thinking their
property would continue to appreciate
and interest rates would remain low.
• Borrowers and lenders focused too
much on the borrower’s ability to
cover the low initial payment and
not enough on risk.
• Subprime mortgages jumped from 8
percent of the total in 2001 to 13.5
percent in 2005, as shown in Exhibit
2. These new buyers pushed housing
prices higher. The increase in the
lending to “subprime” borrowers
helped inflate the housing bubble.
The Subprime Share of Home Mortgages Grows
Rapidly Before the Big Decline (1995–Q2 2008)
• The rising housing prices then
led to overly optimistic
expectations, with both borrowers
and lenders thinking that with
housing prices increasing, the
risks were minimal. (After all,
housing prices jumped almost 10
percent a year nationally from
2000–2006, as shown in Exhibit
3.)
The Recent Run-Up of Nominal Home Prices
was Extraordinary (1890–Q2 2008)
Who Bought These Risky
Subprime Mortgages?
• Many of these risky subprime
mortgages were sold to investors
such as Bear Stearns and Merrill
Lynch. They pooled them with
other securities into packages
and sold them all over the world.
• Part of the impetus for them was
the great demand for mortgage-
backed securities in the global
market.
• A mortgage-backed security (MBS) is a
package of mortgages bundled together
and then sold to an investor, like a
bond.
• Security rating agencies gave their
highest ratings to these securities.
• High ratings encouraged investors to
buy securities backed by subprime
mortgages, helping finance the
housing boom.
• The rating agencies clearly
underestimated the risk of these
securities.
• To complicate matters further,
consumers borrowed hundreds of
billions of dollars against the
equity from the appreciation in
their homes, fueling consumption
spending, and an increase in
household debt, combined with a
fall in personal saving.
• The low interest rates subsidized
massive borrowing, and credit
market debt soared as well.
The Fed Raises Interest Rates
and the Housing Bust
• The low interest rates of the
2002–2004 period and other
factors led to the Fed becoming
concerned about rising prices.
• In 2005–2006, therefore, the Fed
reversed course and pushed short-
term interest rates up, as shown
in Exhibit 1.
• For those holding new adjustable
rate mortgages (ARMs), it meant
their monthly payments rose. Higher
interest rates and falling housing
prices were a recipe for disaster.
• Consequently, many homes went into
default and foreclosure—both
subprime borrowers and prime
borrowers lost their homes. (The
default rate was much lower on those
holding fixed mortgage rates.)
• As housing prices fell and
interest rates rose, foreclosures
jumped. Once home prices fell
below loan values, borrowers could
not qualify to refinance and many
were forced into foreclosure.
• When houses turn “upside down”—
people owe more on their loan than
the house is worth—many walk away
from their houses.
• When housing prices fell and
mortgage delinquencies soared,
the securities-backed subprime
mortgages lost most of their
value.
• When subprime borrowers
defaulted, the investors that
took the hit started demanding
their money back by surrendering
these securities to the banks.
• Banks ended up receiving a double
hit. Their securities investors
started demanding money and their
borrowers were failing to pay
their loans.
• Troubled banks were not able to
raise more money, because other
banks and investors sensed that
they were in trouble and refused
to lend to them.
• Financial markets depend on lenders
making funds available to borrowers.
However, when lenders become reluctant
to make loans, it becomes difficult to
assess credit risk.
• This happened in 2008, which led the
Federal Reserve and other central banks
around the world to pour hundreds of
billions of dollars (euros, pounds,
etc.) into credit markets to ease the
pain of the financial crisis.

Chapter 13 Financial Markets Saving Investment

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Chapter 13 Financial Markets Saving Investment

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chapter

• Investments are necessary for

• The owners of corporations own

• A company can raise money by

• The two most important financial

Reading a Stock Table

• Financial intermediaries are

• For the economy as a whole, total

• Households make their saving

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