Saving, Investment, and the Financial System Premium PowerPoint Slides by Ron Cronovich © 2012...

Saving, Investment, and the Financial System Premium

PowerPoint Slides by

Ron Cronovich

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

N. Gregory Mankiw

Macroeconomics

Principles of

Sixth Edition

13


22

In this chapter, look for the answers to these questions:

• What are the main types of financial institutions in the U.S. economy, and what is their function?

• What are the three kinds of saving?

• What’s the difference between saving and investment?

• How does the financial system coordinate saving and investment?

• How do govt policies affect saving, investment, and the interest rate?


33

National Income Accounts

Rules of national income accounting Important identities

Identity An equation that must be true because of the

way the variables in the equation are defined Clarify how different variables are related to one

another

3© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.


44

Accounting Identities

Gross domestic product (GDP) Total income Total expenditure

Y = C + I + G + NX• Y= gross domestic product GDP• C = consumption• G = government purchases• NX = net exports



55


Closed economy Doesn’t interact with other economies NX = 0 (of course, NX also equals 0 when exports

equal imports. But that’s not what we mean here)

Open economy Interact with other economies NX ≠ 0



66


Assumption: close economy: NX = 0• Y = C + I + G

National saving (saving), S• Total income in the economy that remains after

paying for consumption and government purchases

• Y – C – G = I• S = Y – C - G• S = I



77


T = taxes minus transfer payments• S = Y – C – G• S = (Y – T – C) + (T – G)

Private saving, Y – T – C Income that households have left after paying

for taxes and consumption

Public saving, T – G Tax revenue that the government has left after

paying for its spending



88


Budget surplus: T – G > 0 Excess of tax revenue over government

spending

Budget deficit: T – G < 0 Shortfall of tax revenue from government

spending



99

Saving and Investing

Accounting identity: S = I

Saving = Investment For the economy as a whole One person’s savings can finance another

person’s investment


A C T I V E L E A R N I N G 1

A. Calculations

Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the government spends $2 trillion and has a budget deficit of $300 billion.

Find public saving, taxes, private saving, national saving, and investment.



Answers, part A

Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

Public saving = T – G = – 0.3

Taxes: T = G – 0.3 = 1.7

Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8

National saving = Y – C – G = 10 – 6.5 = 2 = 1.5

Investment = national saving = 1.5



B. How a tax cut affects saving

Use the numbers from the preceding exercise, but suppose now that the government cuts taxes by $200 billion.

In each of the following two scenarios, determine what happens to public saving, private saving, national saving, and investment.

1. Consumers save the full proceeds of the tax cut.

2. Consumers save 1/4 of the tax cut and spend the other 3/4.


Clicker question!

Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

If T is reduced by 0.2 and households save all of it, what is the new level of public savings?

A. 0.1

B. 0.3

C. 0.5

D. 0.7© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Another cl icker question!

Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

If T is reduced by 0.2 and households save all of it, what is the new level of private savings?

A. 1.6

B. 1.8

C. 2.0


Yet another cl icker question!

Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

If T is reduced by 0.2 and households save all of it, what is the new level of national savings?

A. 1.3

B. 1.5

C. 1.7


Last c l i cker quest ion fo r the moment !

Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

If T is reduced by 0.2 and households save all of it, what is happens to private investment?

A. It goes down by 0.2.

B. Nothing.

C. It goes up by 0.2.

D. All of the above.© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.


Answers, part B

In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion.

1. If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged.

2. If consumers save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion.



C. Discussion questions

The two scenarios from this exercise were:1. Consumers save the full proceeds of the

tax cut. 2. Consumers save 1/4 of the tax cut and spend

the other 3/4.

Which of these two scenarios do you think is more realistic?

Why is this question important?



1919

You are wurffless, Alec Baldwin!


2020

The Market for Loanable Funds

A supply–demand model of the financial system

Helps us understand how the financial system coordinates

saving & investment how govt policies and other factors affect

saving, investment, the interest rate


2121


Assume: only one financial market

All savers deposit their saving in this market.

All borrowers take out loans from this market.

There is one interest rate, which is both the return to saving and the cost of borrowing.


2222


The supply of loanable funds comes from saving: Households with extra income can loan it out

and earn interest. Public saving, if positive, adds to national

saving and the supply of loanable funds. If negative, it reduces national saving and the supply of loanable funds.


2323

The Slope of the Supply Curve

InterestRate

Loanable Funds ($billions)

Supply

An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.

60

3%

80

6%


2424

The Market for Loanable FundsThe demand for loanable funds comes from investment: Firms borrow the funds they need to pay for

new equipment, factories, etc. Households borrow the funds they need to

purchase houses.


2525

The Slope of the Demand Curve

InterestRate


Demand

A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.

50

7%

4%

80


2626

Equilibrium

InterestRate


Demand

The interest rate adjusts to equate supply and demand. Supply

The eq’m quantity of L.F. equals eq’m investment and eq’m saving.

5%

60


2727

Policy 1: Saving Incentives

InterestRate


D1

Tax incentives for saving increase the supply of L.F.S1

5%

60

S2

…which reduces the eq’m interest rate

and increases the eq’m quantity of L.F. (but if T actually goes down, S shifts back!)

4%

70


2828

Policy 2: Investment Incentives

InterestRate


D1

An investment tax credit increases the demand for L.F.S1

5%

60

…which raises the eq’m interest rateand increases the eq’m quantity of L.F. (but if T actually goes down, S shifts back!)

6%

70

D2


Budget deficits

Use the loanable funds model to analyze the effects of a government budget deficit: Draw the diagram showing the initial

equilibrium. Determine which curve shifts when the

government runs a budget deficit. Draw the new curve on your diagram. What happens to the equilibrium values of the

interest rate and investment?



Answers


InterestRate


D1

A budget deficit reduces national saving and the supply of L.F.

S1

5%

60

S2 …which increases the eq’m interest rate

and decreases the eq’m quantity of L.F. and private investment. (But it may increase public investment!)

6%

50


3232

Budget Deficits, Crowding Out, and Long-Run Growth

Our analysis: Increase in budget deficit may cause a decline in private investment. The govt borrows to finance its deficit, leaving less funds available for private investment.

This is called crowding out. (This has not been an important problem in the recent past. )

Recall from the preceding chapter: Investment is important for long-run economic growth. If government borrowing isn’t spent wisely, budget deficits may reduce the economy’s growth rate and future standard of living.


3333

The U.S. Government Debt

The government finances deficits by borrowing (selling government bonds).

Persistent deficits lead to a rising govt debt.

The ratio of govt debt to GDP is a useful measure of the government’s indebtedness relative to its ability to raise tax revenue.

Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime—until the early 1980s.


3434

The history of U.S. government debt Debt of U.S. federal government

As a percentage of U.S. GDP Fluctuated

0% of GDP in 1836 107% of GDP in 1945

Declining debt-GDP ratio Government indebtedness is shrinking relative to

its ability to raise tax revenue Government could be living within its means Government could also be reducing public

investment



3535

The history of U.S. government debt Rising debt-GDP

Government indebtedness is increasing relative to its ability to raise tax revenue Fiscal policy cannot be sustained forever at current

levels

War – primary cause of fluctuations in government debt: Debt financing of war – appropriate policy

Tax rates – smooth over time Shifts part of the cost to future generations


1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 20100%

20%

40%

60%

80%

100%

120%

U.S. Government Debt as a Percentage of GDP, 1790–2010

Revolutionary War

Civil War WW1

WW2

63.6% in 2010


3737

The history of U.S. government debt President Ronald Reagan, 1981

Large increase in government debt – not explained by war

Committed to smaller government and lower taxes

Cutting government spending - more difficult politically than cutting taxes

Period of large budget deficits Government debt: 26% of GDP in 1980 to 50% of

GDP in 1993



3838

The history of U.S. government debt President Bill Clinton, 1993

Major goal - deficit reduction And Republicans took control of Congress, 1995

Deficit reduction Substantially reduced the size of the government

budget deficit Eventually: surplus By the late 1990s: debt-GDP ratio - declining



3939

The history of U.S. government debt President George W. Bush

Debt-GDP ratio - started rising again Budget deficit

Several major tax cuts 2001 recession - decreased tax revenue and

increased government spending Spending on homeland security

– Following the September 11, 2001 attacks– Subsequent wars in Iraq and Afghanistan– Increases in government spending



4040

The history of U.S. government debt 2008, financial crisis and deep recession

Dramatic increase in the debt-GDP ratio Increased budget deficit Several policy measures passed by the Bush and

Obama administrations Aimed at combating the recession Reduced tax revenue Increased government spending



4141

The history of U.S. government debt 2009 and 2010

Federal government’s budget deficit = 10% of GDP

Borrowing to finance budget deficit Substantial increase in the debt-GDP ratio

Policy challenges for future generations Putting the federal budget back on a sustainable

path Stable or declining debt-GDP ratio



4242

Financial Institutions

The financial system: the group of institutions that helps match the saving of one person with the investment of another.

Financial markets: institutions through which savers can directly provide funds to borrowers. Examples:

The Bond Market. A bond is a certificate of indebtedness.

The Stock Market. A stock is a claim to partial ownership in a firm.


4343

Financial Institutions

Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers. Examples: Banks

Mutual funds – institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds


4444

The Meaning of Saving and Investment

Private saving is the income remaining after households pay their taxes and pay for consumption.

Examples of what households do with saving: Buy corporate bonds or equities Purchase a certificate of deposit at the bank Buy shares of a mutual fund Let accumulate in saving or checking accounts


4545

The Meaning of Saving and Investment

Investment is the purchase of new capital.

Examples of investment: General Motors spends $250 million to build

a new factory in Flint, Michigan. You buy $5000 worth of computer equipment

for your business. Your parents spend $300,000 to have a new

house built.


4646

CONCLUSION Like many other markets, financial markets are

governed by the forces of supply and demand.

One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity.Financial markets help allocate the economy’s scarce resources to their most efficient uses.

Financial markets also link the present to the future: They enable savers to convert current income into future purchasing power, and borrowers to acquire capital to produce goods and services in the future.

S U M M A RY

• The supply of loanable funds comes from saving. The demand for funds comes from investment. The interest rate adjusts to balance supply and demand in the loanable funds market.

• A government budget deficit is negative public saving, so it reduces national saving, the supply of funds available to finance investment.

• When a budget deficit crowds out investment, it reduces the growth of productivity and GDP.


S U M M A RY

• National saving equals private saving plus public saving.

• In a closed economy, national saving equals investment. The financial system makes this happen.

• The U.S. financial system is made up of many types of financial institutions, like the stock and bond markets, banks, and mutual funds.


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