Savings and Investment

Dr. Katherine Sauer

Principles of Macroeconomics
ECO 2010
1
Overview:

I.The Financial System

II.Savings and Investment
III.Policy
IV.US Deficit and Debt

2
I. The Financial System is the group of institutions in an economy
that help to match savings with investment

The US economy has two basic types of financial institutions:

- financial markets
- financial intermediaries

1. Financial Markets are institutions where funds are transferred

directly from savers to investors.

3
Examples:
a. Bond Market

A bond is a certificate of indebtedness.

“IOU”

When a firm issues bonds to raise money, it is called debt

finance.

When a firm (or government) issues a bond, they are promising

to pay you back a certain value in the future.

A bond has a date of maturity and a rate of interest associated

with it.
Characteristics that determine a bond’s value:
- term: length of time until the bond matures
- usually long term bonds pay a higher interest
rate than short term bonds

- credit risk: the probability that the borrower will fail to

pay the interest or the principal
- the riskier the bond, the higher the interest rate

- tax treatment: some bond interest is tax free

5
b. Stock Market

A stock is a claim of partial ownership of a firm.

When a firm issues stock to raise money, it is called equity finance.

If you buy a stock, you are not guaranteed to get your money back.

Stocks are sold in organized stock exchanges and the prices are
determined by supply and demand.

The price of a stock generally reflects the perception of a firm’s

future profitability.

6
2. Financial Intermediaries are institutions where funds are
transferred indirectly from savers to investors.

Examples:

a.Banks accept savings deposits and make loans.

- pay interest to depositors, charge interest to borrowers

b.Mutual Funds are institutions that sell shares to the public and
use the proceeds to buy a portfolio of stocks and bonds.
- allows individuals with a small amount of money to
diversify

7
II. Savings and Investment

Recall: Investment is important for economic growth

S I K K/L productivity standard of

living

savings = all production – all consumption

(closed economy)

S = Y–C–G
Y=C+I+G
Y–C–G=I
S = I
8
Let’s define National Saving (S) as Y – C – G.
aka Total Saving

Let’s add taxes to this model.

(how could we have G without T?)

S=Y–C–G+T–T

S = (Y – T – C ) + (T – G)

Y – T – C = private savings
T – G = public savings
(aka gov’t savings)

National Savings = Private Savings + Public Savings 9

More on Public Savings:
if T – G > 0, there is a budget surplus
if T – G < 0, there is a budget deficit
if T – G = 0, then the budget is balanced

Recap:
In a closed economy, I = S = Sprivate + Spublic

10
The Market for Loanable Funds
The supply of funds comes from savings.
The demand for funds comes from investment.
The “price” of funds is the real interest rate.
r SF (Savings) The supply of funds slopes
up because as r rises,
people will save a higher
quantity.

The demand for funds

slopes down because as r
rises, firms will borrow a
lower quantity.
DF (Investment)

Quantity of Funds
Level of S 11
Level of I
 The equilibrium occurs
where the supply of funds
equals the demand for
r
funds.
SF (Savings)
If r > r*, the supply would
exceed the demand and
r*
there would be a surplus,
pushing the interest rate
down.

If r < r*, the demand would

exceed the supply and there
DF (Investment)
would be a shortage,
Quantity of Funds pushing the interest rate up.
Q*
Level of S
Level of I
12
The supply curve will shift when total savings changes.
- public savings or private savings

The demand curve will shift when investment changes.

III. Policy

Since investment is good for economic growth, a government

may want to pursue policies that encourage it.

Some government actions result in a decrease in investment.

3 policies
- savings incentives
- investment incentives
- budget deficits

14
1. Savings Incentives
The government can encourage investment indirectly by way of
encouraging savings.

Ways to encourage savings:

- discourage consumption (e.g. sales tax)
- all interest earned to be tax exempt

15
 Ex: Consumption Tax 1) The tax on consumption
would make people buy
less and therefore save
r
more.
SF
- private savings rises
SF2
2) Supply of funds shifts
r1
right

r2 3) r falls

4) Q rises
level of S rises
DF
level of I rises
Quantity of Funds
Q1 Q2
Level of S
Level of I
16
2. Investment Incentives

The government can directly encourage investment.

Ex: investment tax credit

17
 Ex: Tax credit for expanding size of 1) The tax credit would
plant encourage some firms to
expand their size
r
- investment rises
SF
2) Demand for funds shifts
r2 right
r1
3) r rises

4) Q rises
DF2 level of S rises
level of I rises
DF

Quantity of Funds
Q1 Q2
Level of S
Level of I
18
Comparison of policies 1 and 2:

Both result in higher levels of Investment.

Encouraging savings results in a lower interest rate.

Encouraging investment results in a higher interest rate.

Which policy might be better for sustaining long run economic

growth?

19
3. Government Budget Deficits

Because government savings is a component of National

Savings, budget deficits and surpluses affect the market for
loanable funds.
T > G budget surplus, public savings increasing
T < G budget deficit, public savings decreasing

20
 Suppose the government starts running 1) When the government
a larger budget deficit. runs a deficit, public
savings falls
SF2
r
SF 2) Supply of funds shifts
left

r2
3) r rises

r1 4) Q falls
level of S falls
level of I falls
DF

Quantity of Funds
Q2 Q1
Level of S
Level of I
21
This sequence of events is known as crowding out.
- a decrease in investment that results from government
borrowing

When the government runs a deficit, it issues bonds to borrow

money from the public.
Issue price: $18.75
Maturity date: May 2008
Interest over 30 years: $87.92
Final value: $106.67
Treasurydirect.gov 23
IV. US Government Deficit and Debt from the CBO

Nominal numbers!
The deficit figure that gets reported in the news is $-1,413.6 billion.
Revenues – Outlays = deficit
2,104.6 – 3,518.2 = - 1,413.6

This is misleading!

Because Social Security currently takes in more than it spends, the

government “borrows” it for current spending.
The deficit would look larger if this weren’t happening.
Revenues are really 137 less: 137.3 - 0.3 = 137

(-1,413.6) + (- 137) = - 1,550.6

25
Sometimes people say that there were large budget surpluses during
the Clinton years and that Bush lost them.
- misleading!

There was only a true budget surplus in 1999 and 2000.

26
In 2009:
government revenues were the equivalent of 14.8% of GDP
government spending was the equivalent of 24.7% of GDP

The deficit was the equivalent of -10.9% of GDP

The public debt was the equivalent of 53% of GDP
27
- actual debt is higher
From the CBO: Projected Outlays and Revenues as % of GDP

28
From the CBO: Deficit or Surplus as % of GDP

29
 Debt to GDP Percentage
   
  In Hands of Public Gross Debt
U.S. President Party Term Years start end start end
Roosevelt/Truman D 1945-1949 88.3 84.3 97.6 98.2
Truman D 1949-1953 84.3 61.6 98.2 74.3
Eisenhower R 1953-1957 61.6 52.0 74.3 63.9
Eisenhower R 1957-1961 52.0 45.6 63.9 56.0
Kennedy/Johnson D 1961-1965 45.6 40.0 56.0 49.3
Johnson D 1965-1969 40.0 33.3 49.3 42.5
Nixon R 1969-1973 33.3 27.4 42.5 37.1
Ford R 1973-1977 27.4 27.5 37.1 36.2
Carter D 1977-1981 27.5 26.1 36.2 33.4
Reagan R 1981-1985 26.1 34.0 33.4 40.7
Reagan R 1985-1989 34.0 41.0 40.7 51.9
George H. W. Bush R 1989-1993 41.0 48.1 51.9 64.1
Clinton D 1993-1997 48.1 48.4 64.1 67.1
Clinton D 1997-2001 48.4 34.7 67.1 57.3
George W. Bush R 2001-2005 34.7 36.8 57.3 62.9
George W. Bush R 2005-2009 36.8 40.2 62.9 69.2
Table 7.1 from http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf 30