Expert answer:Reflective Journal
Solved by verified expert:In the economic class, I have to write a journal every week about what I studied in the whole week. So, last week I got chapter10, and I want you to look at the Power Point and write a journal for one page about the info. thanks.
chapter_10_powerpoints.pptx
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CHAPTER
SLIDES
BY
SOLINA LINDAHL
Savings, Investment Spending,
and the Financial System
10(25)
FOOD FOR THOUGHT….
SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING:
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What you will
learn in this chapter
▪ The relationship between savings and investment
spending
▪ Aspects of the loanable funds market, which show how
savers are matched with borrowers
▪ The purpose of the five principal types of financial
assets: stocks, bonds, loans, real estate, and bank
deposits
▪ How financial intermediaries help investors achieve
diversification
▪ Some competing views of what determines asset
prices and why asset market fluctuations can be a
source of macroeconomic instability
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Video
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THE NECESSITY OF FINANCE
Having a good idea isn’t enough to build a
business.
Entrepreneurs need funds: You have to
spend money to make money.
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MATCHING UP SAVINGS AND
INVESTMENT SPENDING
Who pays for private investment spending?
In the modern economy, individuals and
firms that create physical capital often do it
with other people’s money.
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MATCHING UP SAVINGS AND
INVESTMENT SPENDING
Savings–investment spending identity:
savings and investment spending are
always equal for the economy as a whole.
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THE SAVINGS–INVESTMENT SPENDING
IDENTITY IN A CLOSED ECONOMY
GDP = C + I + G.
Total income = total spending. Total income can go to consumer
spending (C) or government purchases of goods and service (G) or be
saved (S).
GDP = C + G + S.
Total income = consumption spending + savings. Total spending
consists of either consumption spending (C + G) or investment
spending (I):
GDP = C + G + I.
Total income = consumption spending + investment spending. Putting
these equations together, we get:
C+G+S=C+G+I
Consumption spending = consumption spending + savings +
investment spending. Subtracting (C + G) from both sides:
S = I or savings = investment spending.
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THE SAVINGS–INVESTMENT
SPENDING IDENTITY
Now let’s take a closer look at savings.
Government can also save (or not).
Budget surplus: excess of tax revenue over government
spending.
Budget deficit: excess of government spending over tax
revenue.
Budget balance: the difference between tax revenue and
government spending.
National savings: the sum of private savings and the
budget balance (the total amount of savings generated
within the economy).
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THE SAVINGS–INVESTMENT SPENDING
IDENTITY IN A CLOSED ECONOMY
SGovernment = T − TR − G
T = the value of tax revenues and TR = the value of
government transfers.
SNational = SGovernment + SPrivate
And since S = I has been established, we can say
SNational = I
National savings = investment.
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THE DIFFERENT KINDS OF CAPITAL
It’s important to stay clear about the different
kinds of capital (as explained in the previous
chapter):
1. Physical capital consists of manufactured
resources, such as buildings and machines.
2. Human capital is the improvement in the labor
force generated by education and knowledge.
3. Financial capital is funds from savings that are
available for investment spending.
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C
OPYRIGHT
2015 W
ORTH
P
UBLISHERS
THE SAVINGS–INVESTMENT SPENDING
IDENTITY IN AN OPEN ECONOMY
What happens when a country sends savings to or
receives savings from abroad? This affects
national savings.
Net capital inflow is the total flow of funds into a
country minus the total flow of funds out of a
country.
A country with a positive net capital inflow has an
extra flow of funds from abroad that can be used
for investment spending.
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THE SAVINGS–INVESTMENT SPENDING
IDENTITY IN AN OPEN ECONOMY
A country that spends more on imports than it earns from
exports must borrow the difference from foreigners.
NCI = IM − X
Net capital inflow = imports − exports.
Rearrange GDP = C + I + G + X − IM… to
I = (GDP − C − G) + (IM − X)
We know that GDP − C − G is equal to national savings,
I = SNational + (IM − X) = SNational + NCI
Investment spending = national savings + net
capital inflow.
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LEARN BY DOING: PRACTICE QUESTION
Capital inflow is the:
a) net inflow of foreign funds plus domestic
savings into an economy.
b) net inflow of funds into a country, or the total
inflow of foreign funds into a country minus the
total outflow of domestic funds to other
countries.
c) total outflow of domestic funds to other
countries minus the net inflow of foreign funds
into a country.
d) total outflow of domestic funds to other
countries plus the net inflow of foreign funds
into a country.
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LEARN BY DOING: PRACTICE QUESTION
Suppose a country exports $50 million worth
of goods and services, while it imports $60
million worth of goods and services. This
country
a. has a positive capital inflow.
b. lends funds to foreigners.
c. has a negative capital inflow.
d. Answers (a) and (b) are both correct.
e. Answers (b) and (c) are both correct.
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THE SAVINGS–INVESTMENT SPENDING
IDENTITY IN OPEN ECONOMIES
The United States and Germany, 2013
(two large open economies)
Sources: Bureau of Economic Analysis; OECD
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THE MARKET FOR LOANABLE FUNDS
On any given day, the people with money to lend
are not usually the same as people who want to
borrow.
How are savers and borrowers brought together?
Financial markets channel the savings of
households to businesses that want to borrow in
order to purchase capital equipment.
There are many financial markets. For our purposes
we’ll assume one market where savers and
borrowers come together.
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THE MARKET FOR LOANABLE FUNDS
The loanable funds market: a hypothetical
market that illustrates the market outcome of
the demand for funds generated by borrowers
and the supply of funds provided by lenders.
We assume the price of loans is the (nominal)
interest rate.
(Again, we assume a simplified world with just one
interest rate, knowing that the real world contains
many interest rates according to length of loan,
risk, and customers.)
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THE DEMAND FOR LOANABLE FUNDS
The interest rate is the price of
borrowing funds.
Firms borrow more when the interest
rate falls because more projects will
earn enough to pay for themselves.
Interest
rate
A
12%
B
4
Demand for loanable funds, D
0
450
$150
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Quantity of loanable funds
U B L I S (billions
H E R of
S dollars)
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PRESENT VALUE
The demand for loanable funds
An investment is worth making only if it generates
a future return that is greater than the monetary
cost of making the investment today.
Present value is the amount of money needed
today to receive a given amount of money at a
future date given the interest rate.
If you need $1,000 in a year and the interest rate on
savings is r, how much do you need to put in the bank
now (X)?
X × (1 + r) = $1,000. Rearrange: X = $1,000/(1 + r).
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PRESENT VALUE
A firm has two potential investment projects in
mind, each of which will yield $1,000 a year from
now.
Each project has different initial costs:
One requires that the firm borrow $900 right now.
The other requires that the firm borrow $950.
Which of these projects is worth borrowing money
to finance and undertake?
Depends on the interest rate.
A 10% interest rate means $1,000 is worth $909 now, so
only the first project is worth it, since its initial cost ($900)
is less than the present value. More projects are worth it
as interest rate falls.
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THE SUPPLY OF LOANABLE FUNDS
Interest
rate
Supply of loanable funds, S
12%
Y
4
X
$150
0
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Quantity of loanable funds
(billions of dollars)
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THE SUPPLY OF LOANABLE FUNDS
Why does the supply of loanable funds curve
slope upward?
More people are willing to forgo current consumption
and make a loan to a borrower when the interest rate is
higher.
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THE EQUILIBRIUM INTEREST RATE
Interest
rate
Only projects that
are profitable at
an interest rate of
8% or higher are
funded.
12%
S
Offers not accepted from lenders
who demand interest rate of more
than 8%.
8
E
r*
Projects with rate of
return less than 8% are
not funded.
4
Offers accepted
from lenders willing
to lend at interest
rate of 8% or less.
D
0
$300
Quantity of loanable funds
(billions of dollars)
Q*
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SHIFTS OF THE DEMAND FOR
LOANABLE FUNDS
Factors that can cause the demand curve for
loanable funds to shift:
1. changes in perceived business opportunities
2. changes in government borrowing
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INCREASE IN THE DEMAND FOR
LOANABLE FUNDS
Interest
rate
S
An increase in the
demand for
loanable funds . . .
r2
. . . leads to a
rise in the
equilibrium
interest rate.
r1
D2
D1
Quantity of loanable
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SIDE EFFECTS OF GOVERNMENT
BORROWING?
Crowding out occurs when a government budget deficit
drives up the interest rate and leads to reduced investment
spending.
Crowding out is not a concern in a depressed economy;
rather, increased government spending raises income (and
private savings).
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SHIFTS OF THE SUPPLY OF LOANABLE
FUNDS
Factors that can cause the supply curve for
loanable funds to shift include:
1. changes in private savings behavior.
2. changes in net capital inflows.
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AN INCREASE IN THE SUPPLY OF
LOANABLE FUNDS
Interest
rate
S1
S2
r1
. . . leads to
a fall in the
equilibrium
interest rate.
An increase in the
supply of loanable
funds . . .
r2
D
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Quantity
of loanable funds
B L I S H E R S
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INFLATION AND INTEREST RATES
Anything that shifts either the supply of loanable
funds curve or the demand for loanable funds
curve changes the interest rate.
Major changes in interest rates have been driven
by many factors, including:
▪ changes in government policy.
▪ technological innovations that created new
investment opportunities.
But most important, people’s expectations about
future inflation.
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INFLATION AND INTEREST RATES
Real interest rate = nominal interest rate – inflation
rate.
The true cost of borrowing (and payoff to lending)
is the real interest rate.
But neither lenders nor borrowers know what
inflation will be, so loan contracts specify a
nominal interest rate.
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LEARN BY DOING: PRACTICE QUESTION
If the yearly nominal interest rate on a
savings account is 5% and the rate of
inflation over the same period is 2%,
what is the real interest rate?
a) 5%
b) 2%
c) 7%
d) 3%
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THE FISHER EFFECT
According to the Fisher effect, an increase in
expected future inflation drives up the nominal
interest rate, leaving the expected real interest
rate unchanged.
If the tide rises, these boats will
still float on the surface.
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THE FISHER EFFECT
The expected real interest rate is unaffected by changes in
expected future inflation.
Supply of loanable funds
at 10% expected inflation
Demand for loanable funds
at 10% expected inflation
Nominal
Interest
rate
S10
E10
14%
Supply of loanable
funds at 0%
expected inflation
Demand for loanable funds
at 0% expected inflation
4
D10
S0
E0
D0
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B L I S of
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ECONOMICS
IN ACTION
60 YEARS OF U.S. INTEREST RATES
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LEARN BY DOING: DISCUSS
With a partner, answer the following:
Suppose that expected inflation rises from
3% to 6%.
a) How will the real interest rate be affected
by this change?
b) How will the nominal interest rate be
affected by this change?
c) What will happen to the equilibrium
quantity of loanable funds?
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THE FINANCIAL SYSTEM
Most economies have some sort of financial
system to handle household wealth and make
loans.
Wealth is the value of a household’s accumulated
savings.
A financial asset is a paper claim that entitles the
buyer to future income from the seller.
A physical asset is a tangible object that can be
used to generate future income.
A liability is a requirement to pay income in the
future.
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THE NEED FOR A SOUND FINANCIAL
SYSTEM
A well-functioning financial system is
a critical ingredient in achieving longrun growth because it encourages
greater savings and investment
spending.
It also ensures that savings and
investment spending are undertaken
efficiently.
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THREE TASKS OF A FINANCIAL
SYSTEM
Task 1: reducing transaction costs
Transaction costs: the expenses of negotiating and
executing a deal.
Task 2: reducing risk
Financial risk: uncertainty about future outcomes that
involve financial losses or gains.
Diversification: investing in several assets with
unrelated, or independent, risks; reduces risk.
Task 3: providing liquidity
Liquidity: a measure of how quickly an asset can be
converted into cash with relatively little loss of value.
If it can be converted quickly, it’s liquid; if not, illiquid.
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LEARN BY DOING: PRACTICE QUESTION
Which of the following assets is most liquid?
a) a home with a market value of $300,000
b) a checking account balance of $1,000
c) a three-carat diamond engagement ring
d) a rare edition of an out-of-print book
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LEARN BY DOING: PRACTICE QUESTION
Financial markets provide a means for:
a) reducing risk for borrowers and lenders.
b) reducing transaction costs for borrowers
and lenders.
c) enhancing liquidity for borrowers and
lenders.
d) Answers (a), (b), and (c) are all correct.
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TYPES OF FINANCIAL ASSETS
Bond: an IOU issued by the borrower, usually with
a set interest and maturity date
A concern for investors is the possibility of default
(failure of a borrower to make payments as specified)
More risky bonds carry higher interest rates
Loan-backed securities: assets created by
pooling individual loans and selling shares in that
pool (a process called securitization)
With so many loans packaged together, it can be
difficult to assess the true quality of the asset, as in the
financial crisis of 2008.
Stock: a share in the ownership of a company
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FINANCIAL INTERMEDIARIES
Financial intermediary: an institution that
transforms the funds it gathers from many
individuals into financial assets.
mutual funds
pension funds and life insurance
companies
banks
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WHAT HAPPENS WHEN
INTERMEDIATION FAILS?
When large banks fail, they can take down
the economy.
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MUTUAL FUNDS
It’s hard for people without large amounts of
money to build a diversified portfolio. The solution
is mutual funds.
Mutual fund: financial intermediary that builds a
stock portfolio and resells shares of this portfolio to
individual investors.
Fidelity Spartan 500 Index
Fund top holdings (as of
November 2014)
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PENSION FUNDS AND LIFE INSURANCE
COMPANIES
Pension fund: a type of mutual fund that holds
assets to provide retirement income to its
members.
Life insurance company: sells policies that
guarantee a payment to a policyholder’s
beneficiaries when the policyholder dies.
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BANKS
Bank: a financial intermediary that
provides liquid assets in the form of bank
deposits to lenders and uses those funds
to finance the illiquid investment
spending needs of borrowers who don’t
want to use the stock or bond markets.
Bank deposit: a financial asset (a claim
on the bank’s cash) owned by the
depositor—and a liability of the bank
that holds it.
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BONDS VERSUS BANKS
Is it the increased appetite for risk that causes
U.S. companies to issue a lot more bonds than
their European counterparts?
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BANKS AND THE SOUTH KOREAN
MIRACLE
In 1965 the South Korean government reformed the
country’s banks and increased …
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