SAVING , INVESTMENT AND THE FINANCIAL SYSTEM

Introduction

Investment is financed by saving. There are various ways to finance capital investments:

1. Borrow the money,   from a bank or from a friend or relative.Alternatively, convince someone to provide the money in exchange for a share of future profits.
   
2. Use own savings.

In all cases, investment is financed by someone else’s saving. The financial system consists of those institutions in the economy that helps to match one person’s saving with another person’s investment.

FINANCIAL INSTITUTIONS

The financial system moves the economy’s scarce resources from savers (people who spend less than they earn) to borrowers (people who spend more than they earn).

• Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date.

• Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date.

The financial system is made up of various financial institutions that help coordinate savers and borrowers.

Financial institutions can be grouped into two categories—financial markets and financial intermediaries.

FINANCIAL MARKETS

Financial markets are the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow.

The two most important financial markets are the bond market and the stock market.

The Bond Market

When a firm wants to borrow to finance construction of a new factory, it can borrow directly from the public. It does this by selling bonds.

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

• It identifies the time at which the loan will be repaid, called the date of maturity, and the rate of interest that will be paid.

• The buyer can hold the bond until maturity or can sell it at an earlier date to someone else.

• The interest rate on a bond depends, in part, on its term. Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal.  Long-term bonds usually pay higher interest rates than short-term bonds.

The Stock Market

Another way for a firm to raise funds is to sell stock in the company.

• Stock represents ownership in the firm and is, therefore, a claim to the profits that the firm makes.

• The sale of stock to raise money is called equity finance, whereas the sale of bonds is called debt finance.

• If the firm is very profitable, the stockholders enjoy the benefits of these profits, whereas the bondholders get only the interest on their bonds.

• Compared to bonds, stocks offer the holder both higher risk and potentially higher return.

• After a corporation issues stock by selling shares to the public, these shares trade among stockholders on organized stock exchanges.

FINANCIAL INTERMEDIARIES

Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Two of the most important financial intermediaries are banks and mutual funds.

Banks  

Small businesses usually refer to banks to obtain loans. A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow. Banks facilitate purchases of goods and services by allowing people to write checks against their deposits. In other words, banks help create a special asset that people can use as a medium of exchange.

Mutual Funds

A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds.

The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio raises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss.

• The primary advantage of mutual funds is that they allow people with small amounts of money to diversify.

• A second advantage claimed by mutual fund companies is that mutual funds give ordinary people access to the skills of professional money managers.

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS

Events that occur within the financial system are central to understanding developments in the overall economy.The institutions that make up this system—the bond market, the stock market, banks, and mutual funds— have the role of coordinating the economy’s saving and investment. Macro economists need to understand how financial markets work and how various events and policies affect them. As a starting point for an analysis of financial markets, it is useful  to  discuss the key macroeconomic variables that measure activity in these markets.

IMPORTANT IDENTITIES:

Y = C + I + G + NX

The equation above is an identity because every dollar of expenditure that shows up on the left-hand side also shows up in one of the four components on the right-hand side. In a closed economy,

        Y = C + I + G
Y – C – G = I

The left-hand side of this equation is the total income that remains after paying for consumption and government purchases. This amount is called national saving, or just saving, and is denoted S.  Thus:

S = I

Let T denote the amount that the government collects from households in taxes minus the amount it pays back to households in the form of transfer payments. We can then write national saving in either of two ways:

S  = Y  - C -  G  or   S = (Y - T - C)  + (T - G)

These equations are the same, but each reveals a different way of thinking about national saving. The second equation separates national saving into private saving (Y - T - C) and public saving  (T - G).

• How these accounting identities are related to financial markets? The equation S =I reveal an important fact:
  

  For the economy as a whole, saving must be equal to investment.

• What mechanisms lie behind this identity? What coordinates those people who are deciding how much to save and those people who are deciding how much to invest? The answer is:                                          the financial system.

Although the accounting identity S = I shows that saving and investment are equal for the economy as a whole, this does not have to be true for every individual household or firm.

Banks and other financial institutions make these individual differences between saving and investment possible by allowing one person’s saving to finance another person’s investment.

THE MARKET FOR LOANABLE FUNDS

Assume that the economy has only one financial market, called the market for loanable funds. All savers go to this market to deposit their saving, and all borrowers go to this market to get their loans. In the market for loanable funds, there is one interest rate, which is both the return to  saving and the cost of borrowing.

The economy’s market for loanable funds, like other markets in the economy, is governed by supply and demand. To understand how the market for loanable funds operates, therefore, we first look at the sources of supply and demand in that market.

The supply of loanable funds comes from those people who have some extra income they want to save and lend out.

The demand for loanable funds comes from households and firms who wish to borrow to make investments.

The Impact of different policies on the supply and demand for loanable funds

POLICY 1: TAXES AND SAVING

Saving is an important long-run determinant of a nation’s productivity.

Many economists have proposed changing the tax code to encourage greater saving.

• For example, replace the current income tax with a consumption tax. Under a consumption tax, income that is saved would not be taxed until the saving is later spent. What is the effect of a saving incentive on the market for loanable funds?
• he supply of loanable funds would increase, and the supply curve would shift to the right.

 

POLICY 2: TAXES AND INVESTMENT

• Suppose the government passes a law giving a tax reduction to any firm building a new factory. Because the tax credit would reward firms that borrow and invest in new capital, it would alter investment at any given interest rate and, thereby, change the demand for loanable funds.
• By contrast, because the tax credit would not affect the amount that households save at any given interest rate, it would not affect the supply of loanable funds.

POLICY 3: GOVERNMENT BUDGET DEFICITS (government budget deficits reduce the economy’s growth rate)

• Governments finance budget deficits by borrowing in the bond market, and the accumulation of past government borrowing is called the government debt. National saving—the source of the supply of loanable funds—is composed of private saving and public saving.
• A change in the government budget deficit represents a change in public saving and, thereby, in the supply of loanable funds.
• When the government borrows to finance its budget deficit, it reduces the supply of loanable funds available to finance investment by households and firms.
• Thus, a budget deficit shifts the supply curve for loanable funds to the left . The fall in investment is called crowding out.

A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Summary

•  National income accounting identities reveal some important relationships among macroeconomic variables. In particular, for a closed economy, national saving must equal investment.

• Financial institutions are the mechanism through which the economy matches one person’s saving with another person’s investment.

• The interest rate is determined by the supply and demand for loanable funds.

• To analyze how any policy or event affects the interest rate, one must consider how it affects the supply and demand for loanable funds.

• National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment.

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