Economics: Saving and Investment and the Financial System

Difficulty: 3/3 (Lots of vocab)
Review: 3/5 (Well written for the market for loan-able funds, but needs more explanation on financial intermediaries, to be honest)

The financial system consists of the institutions in the economy that help to match one person's savings to another person's investment.

On the highest level, the financial system moves money from savers to borrowers, and eventually back. Savers spend less than they earn and borrowers spend more than they earn. The institutions that allow this to happen are categorized as either a financial market or a financial intermediary.

Financial markets are institutions through a person who wants to save can directly supply funds to a person who wants to borrow. There's the bond market that sells bonds, like 'IOU's. Bond buyers give there savings to people expecting to get paid back in interest. The use of bond sales to raise money is called debt finance. For a bond, there is a date of maturity; the time for it to reach maturity is known as the term (if it is an infinite term, it's known as perpetuity). There is credit risk to every bond, there is always a chance the borrower will default by declaring bankruptcy. Long term bonds typically have higher risk then, and thus are countered with higher interest rates. Junk bonds are shaky corporation bonds with very high interest. The tax treatment is how tax laws treat bonds. Most bond owners have to pay income tax for the interest on the bond. However, government bonds, municipal bonds, don't have to pay such taxes.

Another form of the financial market is the stock market. Stock represents ownership of a piece of the company, and basically a small claim to the profits of the company. Using stocks to raise money is called equity finance. Typically, stocks are higher risk but also potential higher return than bonds. Some important stock exchanges in the U.S. is the NY stock exchange, American stock exchange, NASDAQ, etc. Stock prices show the perception of the corporation's future success probability. A stock index is computed as an average of a group of stock prices. The Dow Jones Industrial Average, for example, includes 16 major U.S. company stock prices like GM, GE, AT&T, etc. Standard & Poor's 500 index includes 500 company stock prices. Since these prices reflect probability of profitability, they are watched closely to predict future economic conditions.

Now we discuss financial intermediaries, where savers indirectly provide funds to borrowers. The two types are banks and mutual funds. Usually people buy stocks and bonds in familiar large names, but intermediaries allow anyone to borrow a little. Banks, specifically, allow people to loan money, where they profit by charging greater interest on loaners and lower interest on the depositors. Banks also are a medium of exchange. Stocks and bonds are only stores of value for wealth that people accumulated through saving, but banks facilitate purchases of products by allowing people to write checks out of deposits, making it convenient.

The second type of financial intermediary is a mutual fund, an institution that sells shares to the public and uses proceeds to buy a portfolio of various types of stocks and/or bonds. (The book, I quote, reads "stocks, bonds, or both stocks and bonds" ...filler...) The shareholder accepts all risk of the portfolio. The main reason why people use mutual funds is because it allows them to diversify, spread their eggs into multiple baskets. Companies that run mutual funds charge shareholders slightly to manage these portfolios. Now we arrive at the second reason for mutual funds, to allow professional money managers to buy and sell stock accordingly by judging company prospects. (Economists are wary of the second reason, apparently it is hard to "beat the market" since stock is close to measuring true value of a company). One subclass of a mutual fund is called the index fund, instead of using money managers, they just buy all stocks at a stock index and buy and sell rarely to keep costs low.




Remember Y = C + I + G + NX from the GDP chapter. To simplify, we look at a closed economy rather than actual real world economies that are open, so that we do not have to account for imports and exports and interactions with other national economies.

Now, Y = C + I + G since NX = 0.  Rewriting, Y  - C - G = I. The left side of the equation is basically national saving, denoted S, so S = I. Savings equals investment! Incredible!

So S = Y - C - G, and letting T = taxes, then S = (Y - T - C) + (T - G). Note that taxes goes from people to the government to spend. Private saving is about households = (Y - T - C) while public saving is about the government = (T - G). If public saving is positive, the government is saving more tax revenue than spending, called budget surplus. The opposite is called budget deficit.




The market for loan-able funds is a simplified version of the entire financial market, showing supply and demand for loan-able funds. The y-axis is interest rate (IT SHOWS REAL INTEREST RATE, not nominal because real accurately reflects purchasing power and is useful), the x-axis is the loan-able funds dollar amount. The supply curve slopes upwards and comes from saving, and the demand curve slopes downward and comes from investments. Supply and demand shifts occur just as it would with what we've learned in microeconomics.

• Giving saving incentives, like lowering taxes on bonds and such, would make supply shift right.
• Giving investment incentives, like an investment tax credit that gives a tax advantage to any investment in capital, would make demand shift right.
• If G = T, then there is a balanced budget. Unfortunately this rarely happens. Government budget deficits cause government debt that accumulates. Then the government borrows to pay that debt, making total savings go down and supply of loan-able funds to shift left. Government budget surpluses work the opposite, making the supply shift right.

Well, that's the end. Whew, long chapter, lads.

I guess macro is pretty fun, we are getting to learn the bigger picture of economics. It's just that all this is simplified so much. There are a lot of unanswered questions...