Chapter 8 Saving, Investment, and the Financial System

The relationship between inputs and output is summarized by the production function: Y=F(K, L) function has the property of constant returns to scale Meaning: If you change ALL inputs by any positive constant, then output will change by he same constant Let x>0, then zY=F(zK, zL) e.g.Double inputs implies double output 2Y=F(2K, 2L) e.g. Halve inputs implies halve output 1/2Y=F(1/2K, 1/2L) Let z=1/L Then, Y/L = F(K/L, L/L) Rename: y= f(k) Meaning: productivity or output./worker (y) depends on capital/worker(k)

Financial Institutions The financial system: the group of institutions that helps match the saving of one person with the investment of another. Financial markets: institutions through which savers can directly provide funds to borrowers. Examples: The Bond Market. A bond is a certificate of indebtedness. The Stock Market. A stock is a claim to partial ownership in a firm. a bond is a debt e.g.-lent money to the government and the government owes to you if u buy a bond -a stock are shares of equity, claims to ownership Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers. Examples: Banks Mutual funds institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds mutual fund: a pool of resources Saving and Investment in the National Income Accounts Recall that GDP is both total income in an economy and total expenditure on the economys output of goods and services:

Y = C + I + G + NX In a closed economy: Y=C+I+G Different Kinds of Saving Private saving = The portion of households income that is not used for consumption or paying taxes = YTC Public saving = Tax revenue less government spending =TG -Private is people -In the macro level, income =Y -T=tax -C=consumption good -left overs is private savings (assume private savings is always positive) Public is government -collect tax money T -government spending G -can be positive or negative National Saving = 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 Saving and Investment Recall the national income accounting identity: Y = C + I + G + NX For the rest of this chapter, focus on the closed economy case: Y=C+I+G Solve for I: I = Y C G = (Y T C) + (T G) Saving = investment in a closed economy

Budget Deficits and Surpluses Budget surplus = an excess of tax revenue over govt spending = TG = public saving

Budget deficit = a shortfall of tax revenue from govt spending = GT = (public saving) Positive: governments budget surplus Negative: government deficit: spending more than the tax collected The Meaning of Saving and Investment Private saving is the income remaining after households pay their taxes and pay for consumption. Examples of what households do with saving: Buy corporate bonds or equities Purchase a certificate of deposit at the bank Buy shares of a mutual fund Let accumulate in saving or chequing accounts Investment is the purchase of new capital. Examples of investment: Research in Motion spends $250 million to build a new R&D centre in Waterloo, Ontario. You buy $5000 worth of computer equipment for your business. Your parents spend $300,000 to have a new house built. Remember: In economics, investment is NOT the purchase of stocks and bonds! The Market for Loanable Funds A supply-demand model of the financial system Helps us understand how the financial system coordinates saving & investment how govt policies and other factors affect saving, investment, the interest rate Assume: only one financial market All savers deposit their saving in this market. All borrowers take out loans from this market. There is one interest rate, which is both the return to saving and the cost of borrowing. The Financial Market Assumptions 1) There is only one financial market 2) All investment spending (1) is financed by new borrowing 3) Any government budget deficit is financed by new government borrowing (issue bonds) 4) All private savings are used to make new loans to firms or the government (all private savings are in the market) LF^s: loanable funds supply comes from savings decisions LF^d: loanable funds demand comes from borrowing decisions Note: we do not wish to consider consumer or household debt

The supply of loanable funds comes from saving: Households with extra income can loan it out and earn interest. Public saving If positive, adds to national saving and the supply of loanable funds. If negative, it reduces national saving and the supply of loanable funds.

-The relevant price is the interest rate (vertical axis) -quantity of loanable funds is horizontal axis Important identities Y=C+I+G National accounting Identity (eclosed economy) S=Y-C-G National Saving Y-T-C= private saving T-G= public saving S= (Y-T-C)+(T-G) National saving S=I Long-run, closed economy equilibrium condition Financial System: 1) Financial markets (direct) 2) Financial intermediaries (indirect) The market for Loanable Funds LF^s comes from saving decisions LF^D comes from investment decisions When LF^s=LF^D, then S=I (based on the assumptions of the model) 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.

The Slope of the Demand Curve

Equilibrium

Financial Market Equilibrium Since LF^S = S and LF^D = I, Then in equilibrium, LF^S = LF^D Is equivalent to S=I

Saving Incentives Effects of Decrease of Taxes on Savings -decrease of tax on interest income will increase supply of LF (shift right) -in the long run, as decrease of IR, the quantity of LF demanded will increase (increase in investment) ALONG the LF^D curve

Investment incentives Effects of favourable Tax Treatment on Investment Borrowing Decisions -impose a favourable tax treatment from investment spending -increase in the demand for LF (shift right) -in the long-run, increase in IR will Increase the quantity of LF supplied ALONG the LF^s curve

Policy 3: Government Budget Deficits and Surpluses Many of the most pressing policy issues that have arisen over the past 30 years in Canada have either directly or indirectly resulted from large government budget deficits and the debt that accumulated as a result of these deficits. Government debt: the sum of all past budget deficits and surpluses. -if spend more than they earn in one fiscal year = deficit -in surplus money they an put some money in reducing their debt Much public debate over the past 25 years has centred on the effects of these deficits, both on the allocation of the economys scarce resources and on long-term economic growth. Crowding out: a decrease in investment that results from government borrowing. Because investment is important for long-run economic growth, government budget deficits reduce the economys growth rate. When government borrows interest rate rises -> investments go down Vicious circle: cycle that results when deficits reduce the supply of loanable funds, increase interest rates, discourage investment, and result in slower economic growth; slower growth leads to lower tax revenue and higher spending on income support programs, and the result can be even higher budget deficits. S (decrease)= (Y-T-C) + (T-G)negative Virtuous circle: cycle that results when surpluses increase the supply of loanable funds, reduce interest rates, stimulate investment, and result in faster economic growth; faster growth leads to higher tax revenue and lower spending on income-support programs, and the result can be even higher budget surpluses. S (increase) = (Y-T-C) + (T-G) positive

Effects of Government Budget Deficits -public dissaving (T<G) causes a decrease in national saving -decrease in supply of LF (shift left) means fewer LF for the private sector -in the long-run, increase in IR leads to a decrease in quantity of LF demanded ALONG the demand curve -this is called CROWDING OUT

The Accumulation of Government Debt in Canada Budget deficits became a chronic problem in Canada only in the mid1970s. (1975-1997) Because GDP is a rough measure of the governments ability to raise tax revenue, a declining debt-to-GDP ratio indicates that the economy is, in some sense, living within its means. Debt GDP As we saw in the previous chapter, national saving is a key ingredient in longrun economic growth. By using some of the private sectors saving to finance budget deficits, governments pull resources away from investment in new capital and, by doing so, depress the living standard of future generations. Debt/GDP If the size of th debt is increasing faster than the size of GDP, this ratio is increasing In canada, 1996: 72% 2008 32%

CHAPTER SUMMARY The Canadian financial system is made up of many types of financial institutions, like the stock and bond markets, banks, and mutual funds. 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, it reduces the growth of productivity and GDP.