Chapter 26: Saving, Investment, and the Financial System §

(F) Day of the week: Friday Class: IS206 Created Time: April 24, 2020 1:35 PM Database: Class Notes Database Date: April 24, 2020 1:35 PM Days Till Date: Passed Last Edited Time: September 13, 2021 12:41 PM Type: Lecture

Financial System: is a system of institutions that help match a person’s saving with another person’s loan.

I. Financial Institutions §

moves money from savors to borrowers

1. Financial Markets §

Institutions which savors can directly supply fund to the borrowers

• Bond Market
• Stock Market

The Bond Market §

companies can sell bonds to the public and get money to fund a project. Called Debt Finance

• Bond: a certificate of indebtedness, with interest until maturity, People can sell the bond to somebody else before maturity.

  Characteristics of a bond:

  • Term: the length of time until maturity, perpetuity bonds never matures.

    long term bonds usually pays higher interests as its riskier and don’t know when you need the full principle amount.

  • Credit Risk: the probability that the borrower will default, not repaying the debt fully

    • Borrowers could default by declaring bankruptcy
    • The higher the Credit Risk the higher the interest are to compensate for probability of default. (Governments’ bonds pay low interest as it’s very stable)
      • Junk Bonds: corporations with high risk of bankruptcy, putting bond interest very high

  • Tax Treatment: the way tax laws treat interests from the bond. Income tax except gov

    • Municipal Bonds: sold by the government without Income tax payments

The Stock Market §

Equity Finance: the selling of a share of the company to raise funds.

• Stock: the partial ownership of a company sold to the public. Stock holders gain fractions of the profit of the company

  High Reward: if the company grows large, the stockholders profit also.

  High Risk: if the company goes bankrupt, the stockholders receive nothing.

  Organized Stock Exchange: exists in most countries, where stockholders trade stocks based on Demand and Supply determining the price.

  • Stock Index: the measurement of overall stock prices in the economy. Closely watched to see future condition of economy
  • Over-The-Counter: direct trade between buyer and seller of stock without an exchange institution

2. Financial Intermediaries §

is the financial institution that acts as a middle man for savors to indirectly give money to borrowers

Banks §

Smaller businesses (groceries stores…) can’t sell bonds or stocks and have to loan from banks

How it works: loan interests are slightly higher than savings interests with profits covering bank costs and given to the bank owner.

Another purpose of banks: it facilitate purchase of goods and services by giving medium of exchange (checks) that can be easily written and extracted.

Mutual Funds §

an institution selling shares that is used to buy other stocks and bonds in a portfolio. Shareholders accept the risk and rewards if the portfolio falls or rises.

Benefits:

• “Don’t put all your eggs in one basket” if one stock or bond fails you don’t risk everything you have

  Mutual fund institutions spread a person’s money across many different bonds and stocks. Therefore charging 0.25% to 2% of assets each year.

• Ordinary people give their money to skilled professional money manager

  active trading is criticized to be ineffective as good stock will continue to be good, bad ones will continue to be bad and paying professional money managers is just an unnecessary cost.

II. Different Kinds of Saving §

💡 Y: Total Income I: Investment C: Consumption G: Government Spending T: Tax

• In a closed economy (exclude net-export)

  $GDP=C+I+G$

• Private Saving: portion of households’ income that isn’t used for consumption or paying taxes

  $PrivateSavings=Y-T-C$

• Public Savings: Savings made by government by spending less than income (tax)

  $PublicSavings=T-G$

• National Savings

  $NationalSavings=PrivateSaving+PublicSaving$

• Investment

  $I=Y-C-G$

600=2000-100-C

C=600-2000-100=-1500

200=2000+1500-G

G=2000+1500-200

Budget Deficits and Surpluses §

Budget Surplus: an excess of tax revenue over government spending

T-G > 0

+Public Saving

Budget Deficit: a shortfall of tax revenue from government spending

T-G < 0

-Public Spending

• Practice Exercise

  #Active Learning Exercies
  Y = 10T$
  C = 6.5T$
  G = 2T$
  G-T = 0.3T$
  T= G-0.3
  T= 2-0.3 = 1.7/1.5
   
  Public Saving = 0.7-2= -0.3
  Taxes = 1.7
  Private Saving = 10-1.7-6.5=1.8
  National Saving = -0.3 +1.8 = 1.5
  Investment = 10-6.5-2=1.5
   
  ##Case 1: Tax cut & consumer saves all of 200B
  T = 1.5
  Public saving = 1.5-2 = -0.5
  Tax = 1.5
  Private saving = 10-1.5-6.5=2
  National saving = -0.5+2 = 1.5
  Investment = 10-6.5-2=1.5
   
  ##Case 2: Tax cut & consumer saves 1/4 of 200B
  C = 6.5-0.15= 6.65
  T = 1.7-0.05
  Public saving = -0.35
  Private Saving = 10-6.65-1.65
   

Policy 1: Saving Incentive §

lowering saving interest tax rate will give incentive for people to save