Chapter 9

1. Chapter 9 Saving, Investment, and the Financial System

2. Outline • The Supply of Savings • The Demand to Borrow • Equilibrium in the Market for Loanable Funds • The Role of Intermediaries: Banks, Bonds, and Stock Markets • What Happens When Intermediation Fails? • The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking

3. Introduction • Savings are necessary for capital accumulation. • The more capital an economy can invest, the greater is GDP per capita. • Connecting savers and borrowers increases the gains from trade and smoothens economic growth. 3

4. Definition Saving: Income that is not spent on consumption goods. Investment: The purchase of new capital goods.

5. Supply of Savings • Four of the major factors that determine the supply of savings: • Smoothing consumption. • Impatience. • Marketing and psychological factors. • Interest rates. 5

6. Smoothing Consumption • If you consume what you earn every year, consumption is high during your working years. • After retirement consumption drops precipitously. • You can smooth your consumption by saving during the working years and dissaving during the retirement years. • Saving also builds a cushion for unemployment or unexpected health problems. 6

7. Smoothing Consumption 7

8. Impatience • Most individuals prefer to consume now rather than later. • The more impatient a person, the more likely that person’s savings rate will be low. • Impatience is reflected in any economic situation where people must compare costs and benefits over time. • Criminals, addicts, alcoholics, and smokers all tend to discount the future more heavily. 8

9. Definition Time preference: The desire to have goods and services sooner rather than later (all else being equal).

10. Marketing and Psychological Factors • Individuals save more if saving is presented as the natural or default alternative. • The retirement savings plan participation rate was 25% higher in businesses that used automatic enrollment rather than opt in. • The default also mattered for how much was saved. • Simple psychological changes, combined with marketing, can change how much people save. 10

11. The Interest Rate Interest rate Supply of savings 10% The higher the interest rate, the greater the quantity saved 5% Savings (billions of dollars) $200 $280

12. Self-Check Answer: b – patience is one of the major factors, along with consumption smoothing, interest rates, and marketing and psychological factors . Which of the following is a major factor in determining the supply of savings? GDP. Patience. Investment.

13. The Demand to Borrow • One reason people borrow is to smooth consumption. • Many young people borrow to invest in their education. • Borrowing moves some sacrifices into future periods when students’ income is higher. • By borrowing, saving, and dissaving, workers can smooth their consumption over their lifetime. 13

14. The Demand to Borrow The lifecycle theory of savings puts the demand to borrow and save together. 14

15. The Demand to Borrow • Businesses borrow to finance large projects. • Often the people with the best business ideas are not the people with the most savings. • Example: Fred Smith and FedEx • Many ventures cannot “start small” • The ability to borrow greatly increases the ability to invest. • Higher investment increases the standard of living and the rate of economic growth. 15

16. The Demand to Borrow The lower the interest rate, the greater the quantity of funds demanded.

17. Definition Market for loanable funds: Occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers). Trading in the market for loanable funds determines the equilibrium interest rate.

18. The Demand to Borrow • Interest Rates – the “price” of money • Determines the cost of the loan An investment will be profitable only if its rate of return is greater than the interest rate. • The higher the interest rate, the smaller the quantity demanded of savings will be: • There are fewer investments that “make the cut” of yielding a higher return than it costs to borrow the funds to finance the project 18

19. Equilibrium in Loanable Funds • In equilibrium, the quantity of funds supplied equals the quantity of funds demanded. • The interest rate adjusts to equalize savings and borrowing. • If the interest rate is higher than equilibrium, the quantity of savings supplied > the quantity of savings demanded, creating a surplus. • With a surplus of savings, suppliers will bid the interest rate down as they compete to lend. 19

20. Equilibrium in Loanable Funds Interest rate Supply of savings Equilibrium interest rate 8% Demand to borrow Savings/borrowing (in billions of dollars) $250 Equilibrium quantity of savings/borrowing

21. Equilibrium in Loanable Funds Interest rate Supply of savings 10% 8% Demand to borrow Surplus Savings/borrowing (in billions of dollars) $190 $250 $280

22. Equilibrium in Loanable Funds Interest rate Supply of savings 10% 8% 6% Demand to borrow Shortage $200 Savings/borrowing (in billions of dollars) $250 $300

23. Self-Check Answer: a – increase; if there is a shortage, borrowers will bid the rate up. If there is a shortage of loanable funds, the interest rate will: Increase. Decrease. Stay the same.

24. Shifts in Supply and Demand • Changes in economic conditions will shift the supply or demand curve. • The shift will change the equilibrium interest rate and quantity of savings. • Example: • If the stock market crashes, people save more to restore their wealth 24

25. People Become More Thrifty Interest rate Supply of savings New supply of savings Lower interest rate 8% 5% Demand to borrow Savings/borrowing (in billions of dollars) $250 $300 Greater savings and borrowing 25

26. Shifts in Supply and Demand • Example: • Investors become more pessimistic during a recession and reduce their borrowing • Causes demand curve for loanable funds to shift inward (a reduction in demand). 26

27. Investors Become Less Optimistic Interest rate Supply of savings Lower interest rate 8% 5% Demand to borrow New demand to borrow $200 $250 Savings/borrowing (in billions of dollars) Lower savings and borrowing 27

28. Definition Financial intermediaries: Such as banks, bond markets, and stock markets reduce the costs of moving savings from savers to borrowers and investors.

29. The Role of Intermediaries • Equilibrium in the market for loanable funds does not come about automatically. • Savers move their capital to find the highest returns. • Entrepreneurs must find the right investments and the right loans. • Financial intermediaries (“middlemen”) reduce the costs of moving savings from savers to borrowers and help mobilize savings toward productive uses. 29

30. Banks • Banks receive savings from many individuals and pay them interest. • They loan these funds to borrowers, charging them interest. • Banks earn profit by charging more for their loans than they pay for the savings. • They earn this money by providing services such as evaluating investments and spreading risk. 30

31. Banks • By specializing in loan evaluation, banks are better able to decide which business ideas make sense. • It would be wasteful if every saver spent time evaluating the same business. • Banks coordinate lenders and minimize information costs. • Banks spread default risk across many lenders. • Banks also play a role in the payments system. 31

32. Self-Check Answer: c – financial intermediaries reduce the costs of moving savings to investors and mobilize the savings towards productive uses. The main function of financial intermediaries is to: Make capital investments. Provide investment advice. Mobilize savings towards productive uses.

33. The Bond Market • Investors can more easily find information about large, well-known corporations. • They are therefore more willing to bypass banks and lend to these companies directly. • Governments use bonds extensively as well • A corporation acknowledges its debt to a member of the public by issuing a bond, or corporate IOU. • The bond contract lists how much is owed, the rate of interest, and when payment is due. 33

34. The Bond Market • Bonds are a way to raise a large sum of money for long-lived assets, and pay it back over a long period of time. • All bonds involve default risk, or the risk that the borrower will not pay back the loan. • A risky company has to pay higher interest to compensate lenders for a greater risk of default. • Interest rates differ depending on the borrower, repayment time, amount of the loan, type of collateral, and many other features. 34

35. The Bond Market • Major issues are graded by rating companies: • Standard and Poor’s • Moody’s • Grades range from • lowest risk (AAA) • bonds in current default (D) • The higher the risk the greater the interest rate required to get lenders to buy the bonds. 35

36. Definition Collateral: Something of value that by agreement becomes the property of the lender if the borrower defaults.

37. Self-Check Answer: a – this is called collateral. Something of value that becomes the property of the lender if the borrower defaults is called: Collateral. Interest. A bond.

38. Definition Crowding out: The decrease in private consumption and investment that occurs when government borrows more.

39. The Bond Market Supply of savings Government borrows $100b Interest rate An increase in government borrowing crowds out private consumption and investment. 9% b c a 7% Private +$100b govt. demand Private demand Savings/borrowing $150 $200 $250

40. The Bond Market Supply of savings Interest rate An increase in government borrowing crowds out private consumption and investment. The higher interest rate draws forth more savings; private consumption falls. 9% b c a 7% Private +$100b govt. demand Private demand Savings/borrowing $150 $200 $250

41. The Bond Market Supply of savings Interest rate An increase in government borrowing crowds out private consumption and investment. The higher interest rate also reduces the demand to borrow and invest. 9% b c a 7% Private +$100b govt. demand Private demand Savings/borrowing $150 $200 $250

42. U.S. Government Bonds • Treasury securities are desirable because they are easy to buy and sell and the U.S. government is unlikely to default. • T-bonds – 30-year bonds; pay interest every 6 months. • T-notes – maturities ranging from 2 to 10 years; pay interest every 6 months. • T-bills – maturities of a few days to 26 weeks; pay only at maturity. • Zero-coupon bonds – pay only at maturity.

43. Bond Prices and Interest Rates • The value of a bond at maturity is called the face value (FV). • The rate of return, or implied interest rate, on a zero-coupon bond can be calculated as: • If you pay $909 for a 1-year bond with a face value of $1,000: 43

44. Bond Prices and Interest Rates • Equally risky assets must have the same rate of return. • If they didn’t, no one would buy the asset with the lower rate of return. • The price would fall until the rate of return was competitive with other investments. • This is called an arbitrageprinciple. 44

45. Definition Arbitrage: The buying and selling of equally risky assets; arbitrage ensures that equally risky assets earn equal returns.

46. Bond Prices and Interest Rates • Interest rates and bond prices move in opposite directions. • When interest rates go up, bond prices fall; when interest rates go down, bond prices rise. • This tells us that in addition to default risk, people who buy bonds also face interest rate risk. 46

47. Bond Prices and Interest Rates • Assume a long term bond that pays $50/year • Assuming all other factors are constant: • If the prevailing interest rate were 10%, what would you pay to own the bond? • If interest rates fell to 5%, what would you pay to own the bond? • As interest rates fall, the market value of the bond rises, and vice-versa • What happens when interest rates are zero? • Bond market • Stock market 47

48. Self-Check Answer: a – this is called default risk. The risk that a borrower will not pay the loan back is called: Default risk. Interest rate risk. Crowding out.

49. The Stock Market • Businesses can fund their activities by issuing stock, or shares of ownership. • Stocks are traded on organized markets called stock exchanges. • Stock markets encourage investment and growth. • Buying and selling existing shares of stock does not increase net investment in the economy. • When a firm sells new shares to the public (IPO), the proceeds often fund investment. 49

50. Definition Stock: or a share is a certificate of ownership in a corporation. (equity) Initial public offering (IPO): The first time a corporation sells stock to the public in order to raise capital.