Chapter 26

Question 1

What is the function of a financial market?

Answer 1

• financial markets: designed to match the saving of one person with the cash needs of another. That’s what it’s all about - in theory.
• people who have cash = savers
• people who need cash = borrowers (let’s call them that for now)
• the idea is that savers are somehow “matched” with borrowers so that savers’ excess cash can satisfy borrowers’ cash needs.
• but how?

Question 2

Savers can match with borrowers directly . ..

Answer 2

• savers can directly provide funds to borrowers. Examples:
o they can lend $$$ to borrowers.
o either through a loan or by “buying” a loan in the form of a bond > a bond is a certificate of indebtedness
• borrowers OWE + savers lenders are OWED (more on these soon!).

• savers can also provide funds and become part owners of the borrower’s business.
o either directly or through the stock market -> a stock is a claim to partial ownership in a firm
. stockholders OWN something (more on these soon, too!)

Question 3

But direct funding can be hard to do.

Answer 3

• the saver is 100% responsible for:
o finding the borrower;
o assessing the borrower and the potential investment; and o monitoring the activities of the borrower and the performance of her investment -> is the borrower using the
§$$ responsibly and for the reason intended?

Question 4

There may be an easier way. hire a financial intermediary

Answer 4

• financial intermediary: someone who gets in the middle, between the saver and the borrower.
o the intermediary acts as a go-between to (1) find the borrower, (2) assess its reliability, and (3) monitor its behavior.
o the saver pays a small fee to the intermediary for its service in doing these chores.

Question 5

More about financial intermediaries

Answer 5

• financial intermediaries: help savers to indirectly provide funds to borrowers. Examples:
o banks
o mutual funds - institutions that sell shares to the public
* and use the proceeds to buy portfolios of stocks and bonds. The mutual fund managers do all the work in finding, assessing and monitoring the borrower.

Question 6

Again- financial markets are designed to match

Answer 6

• people who have “extra” money (savers) with
• people who need money for a productive purpose (borrowers).

Question 7

What pattern does financial crises follow?

Answer 7

• they occur periodically
• we know they will happen, but we can’t predict WHEN they will occur with any precision.
• they almost always follow a predictable pattern..

Question 8

What happens in a financial crisis?

Answer 8

They almost always follow a predictable pattern. For example, in 2008-2009, we saw …
• large decline in some asset prices -> housing prices fell 30%.
• insolvencies at financial institutions -> banks and other institutions failed when many homeowners stopped paying their mortgages.
• decline in confidence in financial institutions -> customers with uninsured deposits began pulling their funds out of financial institutions.

• credit crunch - borrowers unable to get loans because troubled lenders not confident in borrowers’ credit-worthiness.
• economic downturn -> failing financial institutions and a fall in investment caused GDP to fall and unemployment to rise.
• vicious circle -> the downturn reduced profits and asset values, which worsened the crisis.

Question 9

Different kinds of saving

Answer 9

• Private saving (saving by households) = the portion of households’ income that is not used for consumption or paying taxes
=Y-T-C → S
private

Legend
• Y = income
• T = tax payments made by households
• C = consumption by households

Question 10

The meaning of saving and investment

Answer 10

• Private saving is the income remaining after households pay their taxes and pay for consumption.
• how can households save? Put another way, where can savers send their savings to live? o put in under your mattress o deposit $$$ in bank account o buy corporate bonds or stocks directly o buy shares of a mutual fund

Question 11

What’s another type of saving?

Answer 11

• Public saving (saving by the government) = tax revenue - government spending
= T - G -> S public

Legend
• Y = income
• T = tax receipts by the
government note = this is
the same as tax payments made by households)
• G = government spending

Question 12

Private + public saving = national Saving

Answer 12

National saving (saving overall)
= private saving + public saving
= (Y - T - C) + (T - G)
= Y - C - G
= the portion of national income that is not used for consumption or government purchases
That is -> what’s left of your income after you’re done spending

Question 13

How does saving relate to investment?

Answer 13

• recall the national income accounting (GDP) equation:
GDP: Y = C + I + G + NX
• let’s focus first on the case of a closed economy (that is, no trade -> we exclude exports and imports from the equation).
• our GDP equation becomes Y = C + I + G

• if Y = C+ I + G
• then let’s solve for I:
I = Y - C- G = (Y - T- C) + (T - G)
Lesson: saving = investment in a closed economy

Question 14

What is investment?

Answer 14

• investment is the purchase of new physical capital.
• examples of investment:
o General Motors spends $250 million to build a new factory in
Flint, Michigan.
o you buy $5,000 worth of computer equipment for you
business.
o your parents spend $100,000 to have a new house built.
Remember: In economics, investment is NOT the purchase of stocks and bonds!

Question 15

What about public savings (savings by the US government)?

Answer 15

• just like people, the federal governments tries to balance its income (from taxes) with its expenses (on all kinds of stuff).
• sometimes taxes > expenses.
• sometimes taxes < expenses.
• then the government has either a budget surplus or a budget deficit.

Question 16

Budget Surpluses

Answer 16

• Budget surplus (this doesn’t happen very often in the US)
= an excess of tax revenue over government spending
= T - G
= public saving

Question 17

Budget deficits

Answer 17

• Budget deficit (much more common)
= a shortfall of tax revenue from government spending
= G - T
= - (public saving) - public saving is negative!

Question 18

Note: governmental budget deficits are NOT the same as government debt

Answer 18

deficit = how much the government overspends this year
• (taxes - spending) is a negative number debt is the total of all deficits in our entire history

Question 19

How a tax cut affects saving

Answer 19

• 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 all of their tax cut (that is, all $200 billion).
2. consumers save 25% of the tax cut and spend the other 75%.

Question 20

The Market for Loanable Funds

Answer 20

• a supply-demand model of the financial system (and money)
• it helps us understand:
o how the financial system coordinates saving & investment.
• how it matches borrowers with savers
o how government policies and other factors affect saving, investment, the interest rate.

Let’s assume there is only one financial market:
• all savers deposit their savings in this market.
• all borrowers take out loans from this market.
• there is one interest rate, which is both the return to saving (the interest rate paid on your bank account) and the cost of borrowing (the rate borrowers pay on their loans).

The supply of loanable funds comes from saving:
• private saving -> households with extra cash can loan it out and earn interest.
• public saving:
o if public saving is positive (that is, if the government operates at a surplus), it adds to national saving and the supply of loanable funds.
o if it’s negative (the government borrows to pay its bills), it reduces national saving and the supply of loanable funds

Question 21

The Slope of the Supply Curve

Answer 21

Money is a good like any other, and so it follows the Law of Supply.

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

Here:
P = the interest
rate (the price of money)
Q = funds
supplied

Question 22

More about the market for loanable funds

Answer 22

The 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 new houses (and other durable goods, like cars).

Question 23

The Slope of the Demand Curve

Answer 23

A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.
Money is a good like any other, and so it follows the Law of Demand.

Question 24

Equilibrium

Answer 24

The interest rate adjusts to make supply and demand equal.
The equilibrium quantity of loanable funds equals equilibrium investment (demand) and equilibrium saving.

Question 25

How can the equilibrium in the Market for
Loanable Funds change?

Answer 25

• market forces - that is, supply and demand for funds
• government policies

Question 26

What kind of investment incentives?

Answer 26

• Perhaps:
o allowing businesses to deduct more of their investment expenses
• instead of writing off 50% of the cost of a new truck, they can write off 100% - trucks are now cheaper;
• allowing businesses to deduct their investment expenses faster
•instead of writing a new truck off over 5 years, they can write it off over 3 years -> same.
• since firms save $$$ on taxes, this means that:
o the cost of their proposed investment goes down;
o the incentive to invest increases.

Question 27

What if the government is a borrower, not a saver?

Answer 27

• we can use the loanable funds model to analyze the effects of a government budget deficit (if the government is a borrower).

Question 28

Budget Deficits, Crowding Out, and
Long-Run Growth

Answer 28

• an increase in budget deficit causes a fall in investment. Why?
o the government must borrow to finance its deficit.
o when the US government borrows, lenders know they will get repaid*
- we say lending to the US government is “risk free!
• the US government usually goes to the front of the borrowing line.

• The US govt has never defaulted on its debts. There is no risk associated with lending to the government - so we say that the rate the government pays on its borrowing is the “risk free rate!
  • the US government usually goes to the front of the borrowing line.
  • there are less funds available for everyone else - for investment and other things.
  • this is called crowding out (that is, the govt’s borrowing shoves everyone aside.

Question 29

Summary

Answer 29

• the U.S. financial system is made up of many types of financial institutions, like the stock and bond markets, banks, and mutual funds.
• like most 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 allow savers to convert excess current income into future purchasing power (because they earn interest on their savings, and so increase purchasing power)
• they allow borrowers to acquire capital to produce goods and services in the future.

• national saving equals private saving plus public saving.
• in a closed economy, national saving equals investment. The financial system makes this happen.

• 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, theory suggests that it reduces the growth of productivity and GDP.