Transcript PPT

CHAPTER
9
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Saving, Investment,
and the Financial System
CHAPTER 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
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Introduction
In this chapter we learn how the
loanable funds market:
 brings savers and borrowers together
to make both better off.
 gathers savings and allocates it to
the most profitable investments.
 promotes economic growth.
BACK TO
Important Definitions
Saving: income that is not spent on
consumption goods.
Investment: purchase of new capital
goods.
Caution: “Investment” is defined
differently by economists than by
stockbrokers.
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The Supply of Savings
What Determines the Supply of
Savings?
1. Smoothing consumption
2. Impatience
3. Market and psychological factors
4. Interest rates
BACK TO
The Supply of Savings
1. Individuals Want to Smooth Consumption
Save during working years to provide for
retirement.
Savings rises as life expectancy rises (or
retirement age drops)
Manage fluctuations in income.
Save during good times in order to ride out the
bad times.
BACK TO
Savings Help Smooth
Consumption
Income
Consumption
Path A: consumption = income,
Path B: By saving during working
years, consumption can be
smoothed.
Saving
Path B
Dissaving
Path A
Working Years
Retirement
Time
BACK TO
The Supply of Savings
2. Individuals Are Impatient
Time preference: the desire to have goods
and services sooner rather than later.
Anything with immediate costs and future
benefits must overcome time
preference.
•
College education
People who discount future consumption
more will save less now.
BACK TO
Professor Philip Zimbardo (of the famous Stanford prison experiment)
conveys how our individual perspectives of time affect our work,
health and well-being with the animation expertise at RSA Animate.
Time influences who we are as a person, how we view relationships
and how we act in the world. (10:09 minutes)
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Video
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The Supply of Savings
3. Marketing and Psychological Factors
The way choices are presented makes a
difference.
Example 1: Retirement savings plans
Result: Participation in the savings plan
was 25% higher for companies with
automatic enrollment.
Will he give his 401K much thought?
Not necessarily.
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The Supply of Savings
4. The Interest Rate
Interest is the reward for savings.
It’s the “price” of savings.
The higher the interest rate, the greater the
quantity saved.
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The Supply of Savings
Interest
rate
Supply
of savings
10%
The higher the interest
rate, the greater the
amount of savings.
5%
$200
$280
Savings
(billions of dollars)
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The Demand to Borrow
What determines the demand for
borrowing?
1. Smoothing consumption
2. Financing large investments
3. The interest rate
BACK TO
The Demand to Borrow
1. Smoothing Consumption
Lifecycle Theory of Saving
Nobel laureate Franco Modigliani:
By borrowing, saving, and dissaving at
different times in life, workers can
smooth their consumption path,
improving their overall satisfaction.
Governments also smooth
consumption for wars, deficits, etc.
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The Demand to Borrow
Income
Consumption
By borrowing, saving, and dissaving,
workers can smooth their
consumption.
Saving
Consumption
Path
Income Path
Borrowing
Dissaving
Time
College, buying
first home
Prime working
years
Retirement
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The Demand to Borrow
2. Borrowing Is Necessary to Finance
Large Investments
Without the ability to borrow many profitable
investments will not happen.
Example: Fred Smith and FedEx
Many ventures cannot “start small.”
Needed: start-up funds
BACK TO
The Demand to Borrow
3. The Interest Rate
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:
because there are fewer investments that “make the
cut” of yielding a higher return than it costs to
borrow the funds to finance the project.
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The Demand to Borrow
Interest
rate
The higher the interest
rate, the lower the
demand to borrow.
10%
5%
Demand
to borrow
$190
$300
Savings
(billions of dollars)
BACK TO
Equilibrium in the Market for Loanable Funds
The Market for Loanable Funds:
Is where suppliers of loanable funds
(savers) trade with demanders of
loanable funds (borrowers).
BACK TO
Equilibrium in the Market
for Loanable Funds
Interest
rate
Supply
Surplus → ↓ i
10%
Equilibrium
interest
rate
8%
5%
Shortage → ↑ i
Demand
$190 $200
$250
$280 $300
Equilibrium quantity
of savings/borrowing
Savings/borrowing
(in billions of dollars)
BACK TO
Equilibrium in the Market for Loanable Funds
Shifts in Supply and Demand
If Supply or Demand shifts, the equilibrium
interest rate, quantity of savings and
investment will change.
Examples:
The stock market crashes: household wealth
drops → people save more to restore their
wealth.
The economy goes into a recession and
investors become more pessimistic.
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Shifts in Supply and Demand
If Supply or Demand shifts, the equilibrium interest rate, quantity of
savings and invest.
If the stock market crashes, people save more to restore their wealth.
Interest
rate
Results:
1.Lower equilibrium interest rate
2.Greater savings/borrowing
Old Supply
New supply
8%
5%
Demand
$250
$300
Savings/borrowing (in billions of dollars)
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Shifts in Supply and Demand
If investors become more pessimistic during a recession, they
reduce their borrowing.
Interest
rate
Supply
Result:
1.Lower equilibrium interest rate
2.Lower savings/borrowing
8%
5%
Old Demand
New demand
$200
$250
Savings/borrowing (in billions of dollars)
BACK TO
Try it!
If the government gives a tax credit on
investment, then which of the following is TRUE
about the loanable funds market?
a) The demand for loanable funds will
increase, and the interest rate will also
increase.
b) The demand for loanable funds will
decrease, and the interest rate will
decrease.
c) The supply of loanable funds will decrease,
and the interest rate will increase.
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If savers don't feel safe putting their money in
banks or buying bonds, what's the best way to
sum up what's happening in the market for
loanable funds?
a)
b)
c)
d)
Supply of savings falls and the interest rate
falls.
Supply of savings falls and the interest rate
rises.
Demand for savings falls and the interest rate
falls.
Demand for savings falls and the interest rate
To next
rises.
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The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Financial Institutions reduce the costs of
moving savings from savers to borrowers
and investors.
Middlemen who help coordinate financial
markets.
Help move savings to more highly valued uses.
We examine three financial intermediaries:
1. Banks
2. Bond markets
3. Stock markets
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Banks:
Gather savings
Reduce risk by evaluating ability to pay off loans.
Spread risk
When a borrower defaults on a loan, the bank
spreads the loss among many depositors.
Coordinate lenders and borrowers.
Minimize information costs.
Conclusion: Banks help gather savings and
allocate it to the most productive uses.
BACK TO
Try it!
Think-Pair-Share:
Besides decreasing the number
of banks, how do bank failures
hinder financial intermediation?
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The Role of Intermediaries:
Banks, Bonds, and Stock Markets
The Bond Market
A bond is a sophisticated IOU that documents
who owns how much and when payment must
be paid.
Issuing bonds allows borrowing directly from
the public.
Lender: one who buys a bond
Borrower: one who issues a bond
Corporations and governments at all levels
borrow money by issuing bonds.
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
The Bond Market (cont.)
All bonds involve a risk.
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.
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Collateral: something of value that by
agreement becomes the property of the
lender if the borrower defaults.
The higher the collateral the lower the risk (and
therefore interest rate)
Other elements of interest rate determination:
Repayment time
Amount of loan
Type of collateral
Risk of borrower default
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
The Bond Market: Examples
Berkshire Hathaway (Warren Buffett)
• Bond rating: AAA
• Interest rate: 4.48%
Ford Motor Company
Note: lower bond
ratings increase the
cost of borrowing
• Bond rating: B
• Interest rate: 5.76%
Home mortgage rates are lower than vacation loans
because mortgage loans are backed by collateral.
Conclusion: the higher the risk the higher will be the
rate of return.
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
The Bond Market (cont.)
Governments issue bonds to borrow money.
Government borrowing can crowd out private
spending.
Crowding-out: the decrease in private
consumption and investment that occurs
when government borrows more.
Here’s how crowding-out works:
↑borrowing→ ↑interest rate →
↑Saving
↓consumption
↓Investment
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
So, government borrowing Reduces private borrowing
Interest
rate
Govt. borrows
$100 billion
Supply
interest rate due to
demand
9%
b
c
7%
a
private spending of $50
billion due to higher cost of
borrowing (private demand
falls from $200b to $150b)
Private
demand
$150
$200
$250
Private demand
+$100 billion
govt. demand
Savings/borrowing (in billions of dollars)
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Different kinds of U.S. bonds:
T-bonds: 30 year maturity, pay interest every 6 months.
T-notes: 2 to 10 year maturity, pay interest every 6
months.
T-bills: mature in 2 days to 26 weeks, pay interest only at
maturity.
Bonds that pay interest at maturity are called zero-coupon
bonds.
Short-term U.S. government bonds tend to be the safest
assets.
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Bond Prices and Interest Rates
A bond can be sold any time before maturity.
Sellers of bonds compete to attract lenders.
Face Value (FV): how much the bond is worth at
maturity.
Rate of Return: the implied interest rate (%) the
bond earns.
FV - Price
Rate of Return for a zero - coupon bond 
 100
Price
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Example: Suppose a low risk bond will pay
$1,000 one year from now. If you pay $950 for
the bond now, the rate of return on the bond
will be:
$1,000  $950
 100  5.26%
$950
Unless the market rate of interest is less than 5.26%, no
one will buy the bond.
The less paid for the bond, the greater will be the rate of
return.
The higher the market rate of interest, the less anyone will
pay for the bond.
BACK TO
Try it!
Suppose you paid $800 for a zerocoupon bond with a face value of
$1,000. If you held that bond until
maturity, then the rate of return would
be
a) –20%
b) 20%
c) –25%
d) 25%
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The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Takeaways:
1. Equally risky assets must have the same rate of return
If not, there will likely be arbitrage
Arbitrage: the buying and selling of equally risky
assets (to exploit differences in price).
Arbitrage is covered in more detail in the
appendix.
2. Interest rates and bond prices move in opposite
directions
Changing interest rates will change a bond’s
market value.
This means that bond buyers face interest rate risk
along with default risk.
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
The Stock Market
A stock (or a share) is a certificate of
ownership in a corporation.
Stocks are traded in organized
markets called stock
exchanges.
New York Stock Exchange
(NYSE) is the largest.
Tokyo Stock Exchange (TSE) is
the second largest.
BACK TO
The Role of Intermediaries:
Banks, Bonds, and Stock Markets
Sales of new shares:
IPO (initial public offering): the first time a
corporation sells stock to the public in order to
raise capital
Typically used to buy new capital goods.
Stock markets encourage investment and growth.
BACK TO
What Happens When
Intermediation Fails?
The bridge between saving and investment breaks down.
Economic growth suffers.
BACK TO
Richard Thaler, (Professor, The University of Chicago Booth School of
Business): We Failed to Learn From the Hedge Fund Failures of the
Late 90s. His message to overconfident risk managers: there’s more
risk out there than you think. (2:02 minutes)
BACK TO
What Happens When
Intermediation Fails?
Insecure Property Rights
Some governments fail to protect property rights.
Saved funds can be confiscated, frozen, and
otherwise restricted.
Result: people are reluctant to put their savings in
domestic institutions.
Example: Argentina and Brazil
Both have a history of freezing bank accounts.
Argentines and Brazilians save less.
Result: less investment and lower economic
growth.
BACK TO
What Happens When
Intermediation Fails?
Controls on Interest Rates and Inflation
Usury Laws: create legal ceilings on interest rates.
Result: less saving and investment.
Most American states have usury laws but:
They often have loopholes (e.g., don’t apply to
credit cards).
They are set at levels too high to affect most
loan markets.
BACK TO
What Happens When
Intermediation Fails?
Effect of Usury Laws
Interest
rate
8%
Supply
of savings
Market
Equilibrium
Results:
1.Shortage of savings
2.Less savings/investment
3.Slower economic growth
Controlled
Interest rate
Shortage
Demand
$190
$250
$300
Savings/borrowing
(in billions of dollars)
BACK TO
What Happens When
Intermediation Fails?
Inflation
When combined with controls on interest rates,
inflation destroys the incentive to save.
Nominal and real interest rates:
Nominal interest rate: the named rate; the
rate on paper.
Real interest rate: the rate of return after
adjusting for inflation.
Therefore:
Real rate  Nominal rate - Inflation rate
BACK TO
Try it!
If the yearly nominal interest rate on
a savings account is 5%, and the rate
of inflation over the same period of
time is 2%, what is the real interest
rate?
a) 5%
b) 2%
c) 7%
d) 3%
To next
Try it!
What Happens When
Intermediation Fails?
Example: Suppose interest rates are controlled
at a nominal rate of 10% and the rate of
inflation is 30%. Then:
Real rate  10% - 30%  - 20%
Result:
Savers are losing 20% a year.
Saving is discouraged.
Less investment and slower economic
growth.
BACK TO
Negative Interest Rates and Economic Growth
Country
Argentina
Bolivia
Chile
Ghana
Peru
Poland
Sierra Leone
Turkey
Venezuela
Zaire
Zambia
Years
1975-1976
1982-1984
1972-1974
1976-1983
1976-1984
1981-1982
1984-1987
1979-1980
1987-1989
1976-1979
1985-1988
Real Interest
Rate (%)
-69
-75
-61
-35
-19
-33
-44
-35
-24
-34
-24
Per capita
growth (%)
-2.2
-5.2
-3.6
-2.9
-1.4
-8.6
-1.9
-3.1
-2.7
-6.0
-1.9
Source: Easterly (2002, p. 228)
BACK TO
What Happens When
Intermediation Fails?
Politicized Lending and Government Owned
Banks
Example: Japan 1990 to 2005.
Many banks were bankrupt or propped up by the
government (“Zombie banks”).
They were not loaning funds for efficient uses.
Other banks were pressured to lend money to
well-connected political allies.
Result: economic growth was zero during this
period.
BACK TO
What Happens When
Intermediation Fails?
Bank Failures and Panics
Systemic problems usually lead to large-scale economic
crises.
During the Depression, between 1929-1933:
11,000 banks (almost half of U.S. banks) failed.
Ripple effects:
Businesses could not get working capital.
Many people lost their life savings, resulting in
lower spending.
BACK TO
What Happens When
Intermediation Fails?
Result:
Huge amounts of bad loans on the books of
financial institutions.
Banks could not get funds to loan.
The bridge between savers and borrowers
collapsed. Click the image below for a video
clip.
BACK TO
The Financial Crisis of 2007–2008
Financial Crisis 2007-2008
Many mortgage loans were bundled and
sold as if they had very low risk.
Some were sold on false terms.
Credit rating agencies failed at their job.
People expected housing prices to
continue to rise.
Housing prices fell.
Many people defaulted on their mortgages.
BACK TO
The Financial Crisis of 2007–2008: Leverage,
Securitization, and Shadow Banking
1. Leverage:
Since everyone assumed real estate values
would only climb, both households and banks
became much more “leveraged”.
Owner equity is the value of the asset minus the
debt, E = V − D.
The leverage ratio is the ratio of debt to equity, D/E.
An insolvent firm has liabilities that exceed its
assets.
The problem? None… unless real estate drops.
BACK TO
The Financial Crisis of 2007–2008: Leverage,
Securitization, and Shadow Banking
BACK TO
The Financial Crisis of 2007–2008: Leverage,
Securitization, and Shadow Banking
2. Securitization:
Loans can be bundled together (“securitized”)
and then sliced up and sold on the market as
financial assets.
This has benefits:
Provides safety and liquidity for the bank selling the
securitized mortgages
Provides a path for others to invest in the American
economy
And it has costs:
Securitization can hide risk and bad loans.
BACK TO
The Financial Crisis of 2007–2008: Leverage,
Securitization, and Shadow Banking
3. The “Shadow Banking System”
Alternative banks (hedge funds, money
markets and investment banks) have grown up
in the shadow of traditional commercial banks.
2008: these “Shadow banks” loaned $20 trillion
(more than traditional banks)
Shadow banks are not insured by the FDIC, nor
are they heavily regulated.
When investors got worried about Lehman
Brothers’ solvency, it set off a wider bank panic
and government bailouts.
BACK TO
Inside the Meltdown investigates the causes of the worst economic crisis in 70
years and how the government responded. The film chronicles the inside stories
of the Bear Stearns deal, Lehman Brothers' collapse, the propping up of
insurance giant AIG and the $700 billion bailout. It also examines what Treasury
Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke didn't
see and couldn't stop. (56 minutes)
BACK TO
Try it!
Do you think it’s necessary for the
Federal Government (and
taxpayers) to bail out banks when
they are on the verge of collapse?
a) Yes
b) No
BACK TO