Transcript Mankiw: Brief Principles of Macroeconomics, Second Edition

Mankiw: Brief Principles of
Macroeconomics, Second Edition
(Harcourt, 2001)
Ch. 8: Saving and Investment, and the
Financial System
Financial Markets
• Entrepreneurs are people with ideas.
– They need funds to put their ideas into fruition.
• People who have funds would like to get a
high return for them.
• Financial markets bring the savers with
funds (lenders) together with borrowers.
• Savers supply loanable funds and borrowers
demand loanable funds.
Econ 202
Dr. Ugur Aker
2
Financial Markets
• Bond Market
• Stock Market
• Foreign Exchange Market
Econ 202
Dr. Ugur Aker
3
Bonds
• A bond is an IOU.
– Lender gives a sum of money to borrower.
– Borrower gives a piece of paper that indicates
• The amount of interest payment per year to be paid
to the bondholder.
• The amount of principal (face value) to be paid to
the bondholder at the maturity date.
• The date the principal will be paid.
Econ 202
Dr. Ugur Aker
4
Primary and Secondary Markets
• When the bond is first issued it goes to the
primary market.
– The borrower (the issuing firm) gets the funds
and the lender gets the bond.
• The bonds can be resold in the secondary
market.
– The ownership of the bond changes.
– The issuer gets nothing.
– The price of the bond depends on the supply
and demand for similar bonds.
Econ 202
Dr. Ugur Aker
5
Bond Prices and Interest Rates
• A bond that pays $100 per year for 30 years and
sold for $1000 yields an interest return of how
much?
– Roughly 10%.
• The same bond is sold for $1250. What is the
interest return?
– Roughly 8%.
• The same bond is sold for $500. What is the
interest rate?
– Roughly 20%.
Econ 202
Dr. Ugur Aker
6
Bond Prices and Interest Rates
• Bond prices and interest rates are always
inversely related.
• The higher the interest rate, the lower is the
bond price.
• The higher the bond price, the lower is the
interest rate.
Econ 202
Dr. Ugur Aker
7
Different Bonds
• Would you be willing to pay the same price
for the following bonds?
–
–
–
–
US Federal Government bond.
ATT bond.
Cleveland City bond.
LTV Steel bond.
Econ 202
Dr. Ugur Aker
8
Why Do Bonds Have Different Prices?
• Risk
– The higher the risk of default (inability of the issuer to pay
interest or principal), the lower is the price (the higher is the
interest rate).
• Liquidity
– The easier it is to convert the bond into cash in the future, the
higher is the price (the lower is the interest rate).
• Tax considerations
– If the interest payments are tax-free, there will be more
demand for it. Higher price and lower interest rate.
• Maturity
– The farther the maturity date, the lower will be the price (the
higher the interest rate).
Econ 202
Dr. Ugur Aker
9
Stocks
• A firm may choose to raise funds by issuing
stock.
• The stock holder becomes part owner,
sharing the future profits and losses.
• The firm gets the funds from the primary
market.
• The stock exchanges hands in the secondary
market, transferring ownership.
Econ 202
Dr. Ugur Aker
10
Financial Intermediaries
• Financial intermediaries are institutions that
channel the savers’ funds to the borrowers.
• Banks
– Take deposits from savers.
– Lend funds to borrowers.
• Mutual Funds
– Take deposits from savers.
– Buy stock.
Econ 202
Dr. Ugur Aker
11
Econ 202
Dr. Ugur Aker
12
National Investments Match Savings
Y = C + I + G + NX
Y=C+S+T
C + S + T = C + I + G + NX
S + (T – G) – NX = I
Investments will have to be matched by private
savings (S), government savings (T-G), and
foreign savings (-NX).
NX = Exports – Imports
-NX = Imports - Exports
Econ 202
Dr. Ugur Aker
13
Financing US Investments
• In the eighties and well into the nineties the
budget of the government was in deficit.
• How did US keep its investments high?
• Foreign indebtedness.
• The twin deficits were, therefore, related.
Econ 202
Dr. Ugur Aker
14
Loanable Funds
Real
Interest
rate
S
D
The supply of loanable funds
are provided by savers, i.e.,
lenders. The demand for
loanable funds comes from
borrowers. The market
equilibrium is reached at
a specific real interest rate.
Loanable Funds
Econ 202
Dr. Ugur Aker
15
What Happens When
• Tax laws are changed to eliminate taxes
from savings.
• Tax laws are changed to give tax breaks for
investments.
• Government budget deficit increases.
• Government budget surplus increases.
Econ 202
Dr. Ugur Aker
16
Repealing Taxes on Savings
S
S
i1
i2
D
Suppose taxes on interest
earnings were eliminated.
Or income taxes were
replaced by sales taxes. Or
savings to be used for
retirement purposes were
tax free. What would
happen To the real interest
rate and amount of savings
available?
1000 1200
Econ 202
Dr. Ugur Aker
17
Why Don’t We Do It?
• Who benefits from the tax cut?
• How do sales taxes affect the poor and the
rich?
• Who puts more value to present
consumption over future consumption?
Econ 202
Dr. Ugur Aker
18
Investment Tax Credit
When government allows investment
expenditures to be deducted from
earnings (instead of just depreciation),
firms will have more incentive to
expand. Demand to borrow funds
will increase, raising the real interest
rate and the amount borrowed.
S
6%
5%
D
D
Loanable Funds
Econ 202
Dr. Ugur Aker
19
Government Budget Surplus
Interest
rate
S
S
D
When the government budget
shows a surplus, the amount of
savings in the economy rises;
public saving is positive. The
additional funds available will
shift the supply curve to the
right, reducing the interest rate
and increasing the funds used
for investment purposes.
Loanable funds
Econ 202
Dr. Ugur Aker
20
Crowding Out
• When government runs a deficit, national savings
drop because public saving becomes negative.
• The supply curve in the loanable funds market
shifts left.
• Interest rates rise.
• Private entities find it more expensive to borrow,
so they borrow less and undertake lower levels of
investments.
• Private investment is crowded out by the
government’s borrowing.
Econ 202
Dr. Ugur Aker
21
Source: http://www.stls.frb.org/images/publications/net/page17.gif
Econ 202
Dr. Ugur Aker
22