Transcript Chapter 14

Chapter 9
Saving, Investment,
and the Financial
System
MODERN PRINCIPLES OF ECONOMICS
Third Edition
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
2
Introduction
 Savings are necessary for capital accumulation.
 The more capital an economy can invest, the
greater is GDP per capita.
 Connecting savers and borrowers increases
the gains from trade and smoothens economic
growth.
3
Definition
Saving:
Income that is not spent on consumption
goods.
Investment:
The purchase of new capital goods.
4
Supply of Savings
 Four of the major factors that determine the
supply of savings:
•
•
•
•
Smoothing consumption.
Impatience.
Marketing and psychological factors.
Interest rates.
5
Smoothing Consumption
 If you consume what you earn every year,
consumption is high during your working years.
 After retirement consumption drops
precipitously.
 You can smooth your consumption by saving
during the working years and dissaving during
the retirement years.
 Saving also builds a cushion for unemployment
or unexpected health problems.
6
Smoothing Consumption
7
Impatience
 Most individuals prefer to consume now rather
than later.
 The more impatient a person, the more likely
that person’s savings rate will be low.
 Impatience is reflected in any economic
situation where people must compare costs and
benefits over time.
 Criminals, addicts, alcoholics, and smokers all
tend to discount the future more heavily.
8
Definition
Time preference:
The desire to have goods and services
sooner rather than later (all else being
equal).
9
Marketing and Psychological Factors
 Individuals save more if saving is presented as
the natural or default alternative.
 The retirement savings plan participation rate
was 25% higher in businesses that used
automatic enrollment rather than opt in.
 The default also mattered for how much was
saved.
 Simple psychological changes, combined with
marketing, can change how much people save.
10
The Interest Rate
Interest
rate
Supply
of savings
10%
The higher the interest
rate, the greater the
quantity saved
5%
$200
$280
Savings
(billions of dollars)
11
Self-Check
Which of the following is a major factor in
determining the supply of savings?
a. GDP.
b. Patience.
c. Investment.
Answer: b – patience is one of the major factors,
along with consumption smoothing, interest rates,
and marketing and psychological factors .
12
The Demand to Borrow
 One reason people borrow is to smooth
consumption.
 Many young people borrow to invest in their
education.
 Borrowing moves some sacrifices into future
periods when students’ income is higher.
 By borrowing, saving, and dissaving, workers
can smooth their consumption over their
lifetime.
13
The Demand to Borrow
The lifecycle theory of savings puts the demand to borrow
and save together.
14
The Demand to Borrow
 Businesses borrow to finance large projects.
 Often the people with the best business ideas
are not the people with the most savings.
• Example: Fred Smith and FedEx
• Many ventures cannot “start small”
 The ability to borrow greatly increases the
ability to invest.
 Higher investment increases the standard of
living and the rate of economic growth.
15
The Demand to Borrow
 Interest Rates
 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:
 There are fewer investments that “make the cut” of
yielding a higher return than it costs to borrow the
funds to finance the project
16
The Demand to Borrow
17
Definition
Market for loanable funds:
Occurs when suppliers of loanable
funds (savers) trade with demanders of
loanable funds (borrowers). Trading in
the market for loanable funds
determines the equilibrium interest rate.
18
Equilibrium in Loanable Funds
 In equilibrium, the quantity of funds supplied
equals the quantity of funds demanded.
 The interest rate adjusts to equalize savings
and borrowing.
 If the interest rate is higher than equilibrium, the
quantity of savings supplied > the quantity of
savings demanded, creating a surplus.
 With a surplus of savings, suppliers will bid the
interest rate down as they compete to lend.
19
Equilibrium in Loanable Funds
Interest
rate
Supply
of savings
Equilibrium
8%
interest
rate
$250
Demand to
borrow
Equilibrium quantity
of savings/borrowing
Savings/borrowing
(in billions of dollars)
20
Equilibrium in Loanable Funds
Interest
rate
Supply
of savings
10%
8%
Demand to
borrow
$280
$250
$190
Surplus
Savings/borrowing
(in billions of dollars)
21
Equilibrium in Loanable Funds
Interest
rate
Supply
of savings
10%
8%
6%
Demand to
borrow
$300
$250
$200
Shortage
Savings/borrowing
(in billions of dollars)
22
Self-Check
If there is a shortage of loanable funds, the
interest rate will:
a. Increase.
b. Decrease.
c. Stay the same.
Answer: a – increase; if there is a shortage,
borrowers will bid the rate up.
23
Shifts in Supply and Demand
 Changes in economic conditions will shift the
supply or demand curve.
 The shift will change the equilibrium interest
rate and quantity of savings.
 Example:
 If the stock market crashes, people save more
to restore their wealth
24
People Become More Thrifty
Interest
rate
Supply
of savings
New supply
of savings
Lower
interest rate
8%
5%
Demand
to borrow
$250
$300
Greater savings
and borrowing
Savings/borrowing
(in billions of dollars)
25
25
Shifts in Supply and Demand
 Example:
 Investors become more pessimistic during a
recession and reduce their borrowing
26
Investors Become Less Optimistic
Interest
rate
Supply
of savings
Lower
interest rate
8%
5%
Demand to borrow
New demand to borrow
$200 $250
Lower savings
and borrowing
Savings/borrowing
(in billions of dollars)
27
27
Definition
Financial intermediaries:
Such as banks, bond markets, and stock
markets reduce the costs of moving
savings from savers to borrowers and
investors.
28
The Role of Intermediaries
 Equilibrium in the market for loanable funds
does not come about automatically.
 Savers move their capital to find the highest
returns.
 Entrepreneurs must find the right investments
and the right loans.
 Financial intermediaries (“middlemen”)
reduce the costs of moving savings from savers
to borrowers and help mobilize savings toward
productive uses.
29
Banks
 Banks receive savings from many individuals
and pay them interest.
 They loan these funds to borrowers, charging
them interest.
 Banks earn profit by charging more for their
loans than they pay for the savings.
 They earn this money by providing services
such as evaluating investments and spreading
risk.
30
Banks
 It would be wasteful if every saver spent time
evaluating the same business.
 Banks coordinate lenders and minimize
information costs.
 By specializing in loan evaluation, banks are
better able to decide which business ideas
make sense.
 Banks spread default risk across many lenders.
 Banks also play a role in the payments system.
31
Self-Check
The main function of financial intermediaries is
to:
a. Make capital investments.
b. Provide investment advice.
c. Mobilize savings towards productive uses.
Answer: c – financial intermediaries reduce the
costs of moving savings to investors and mobilize
the savings towards productive uses.
32
The Bond Market
 Investors can more easily find information about
large, well-known corporations.
 Governments use bonds extensively as well
 They are therefore more willing to bypass
banks and lend to these companies directly.
 A corporation acknowledges its debt to a
member of the public by issuing a bond, or
corporate IOU.
 The bond contract lists how much is owed, the
rate of interest, and when payment is due.
33
The Bond Market
 Bonds are a way to raise a large sum of money
for long-lived assets, and pay it back over a
long period of time.
 All bonds involve default risk, or the risk that
the borrower will not pay back the loan.
 A risky company has to pay higher interest to
compensate lenders for a greater risk of default.
 Interest rates differ depending on the borrower,
repayment time, amount of the loan, type of
collateral, and many other features.
34
The Bond Market
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.
35
Definition
Collateral:
Something of value that by agreement
becomes the property of the lender if the
borrower defaults.
36
U.S. Government Bonds
 Treasury securities are desirable because they
are easy to buy and sell and the U.S.
government is unlikely to default.
 T-bonds – 30-year bonds; pay interest every 6
months.
 T-notes – maturities ranging from 2 to 10
years; pay interest every 6 months.
 T-bills – maturities of a few days to 26 weeks;
pay only at maturity.
 Zero-coupon bonds – pay only at maturity.
37
Self-Check
Something of value that becomes the property
of the lender if the borrower defaults is called:
a. Collateral.
b. Interest.
c. A bond.
Answer: a – this is called collateral.
38
Definition
Crowding out:
The decrease in private consumption
and investment that occurs when
government borrows more.
39
The Bond Market
Interest
rate
9%
7%
Supply
of savings
Government
borrows $100b
b
c
a
Private
demand
$150 $200
$250
Private +$100b
govt. demand
Savings/borrowing
An increase in government borrowing crowds out private
consumption and investment.
40
The Bond Market
Supply
of savings
Interest
rate
9%
7%
b
c
a
The higher interest
rate draws forth more
savings; private
consumption falls.
Private
demand
$150 $200
$250
Private +$100b
govt. demand
Savings/borrowing
An increase in government borrowing crowds out private
consumption and investment.
41
The Bond Market
Supply
of savings
Interest
rate
9%
7%
b
c
a
The higher interest
rate also reduces the
demand to borrow
and invest.
Private
demand
$150 $200
$250
Private +$100b
govt. demand
Savings/borrowing
An increase in government borrowing crowds out private
consumption and investment.
42
Bond Prices and Interest Rates
 The value of a bond at maturity is called the face
value (FV).
 The rate of return, or implied interest rate, on a
zero-coupon bond can be calculated as:
FV - Price
Rate of return 
 100
Price
 If you pay $909 for a 1-year bond with a face value
of $1,000:
1000 - 909
Rate of return 
 100  10%
909
43
Bond Prices and Interest Rates
 Equally risky assets must have the same rate of
return.
 If they didn’t, no one would buy the asset with
the lower rate of return.
 The price would fall until the rate of return was
competitive with other investments.
 This is called an arbitrage principle.
44
Definition
Arbitrage:
The buying and selling of equally risky
assets; arbitrage ensures that equally
risky assets earn equal returns.
45
Bond Prices and Interest Rates
 Interest rates and bond prices move in opposite
directions.
 When interest rates go up, bond prices fall;
when interest rates go down, bond prices rise.
 This tells us that in addition to default risk,
people who buy bonds also face interest rate
risk.
46
Bond Prices and Interest Rates
 Assume a long term bond that pays $50/year
 Assuming all other factors are constant:
• If the prevailing interest rate were 10%, what would
you pay to own the bond?
• If interest rates fell to 5%, what would you pay to
own the bond?
 As interest rates fall, the market value of the
bond rises, and vice-versa
 What happens when interest rates are zero?
• Bond market
• Stock market
47
Self-Check
The risk that a borrower will not pay the loan
back is called:
a. Default risk.
b. Interest rate risk.
c. Crowding out.
Answer: a – this is called default risk.
48
Definition
Stock:
or a share is a certificate of ownership in
a corporation. (equity)
Initial public offering (IPO):
The first time a corporation sells stock to
the public in order to raise capital.
49
The Stock Market
 Businesses can fund their activities by issuing
stock, or shares of ownership.
 Stocks are traded on organized markets called
stock exchanges.
 Stock markets encourage investment and
growth.
 Buying and selling existing shares of stock does
not increase net investment in the economy.
 When a firm sells new shares to the public
(IPO), the proceeds often fund investment.
50
When Intermediation Fails
 The bridge between savers and borrowers can
be broken in many ways.
51
Insecure Property Rights
 Some governments do not offer secure property
rights to savers.
 Savings may be confiscated, frozen, or subject
to other restrictions.
 When Argentina froze bank accounts in 2001,
many banks went under and Argentinians lost
their savings.
 Russia has at times confiscated or restricted the
value of shareholders’ holdings.
 This negatively affects savings and investment.
52
Controls on Interest Rates
 Price controls on interest rates also cause the
loanable funds market to malfunction.
 Usury laws impose a maximum ceiling on the
interest rate that can be charged on a loan.
 Most U.S. states have usury laws, although
often they have loopholes:
• they don’t stop most credit card borrowing.
• they are set at levels too high to influence
most loan markets.
• Credit card loan sharking at 29.99%
53
Controls on Interest Rates
Interest
rate
Supply
Market
Equilibrium
8%
Controlled
Interest rate
1. Shortage of savings
2. Less savings and
investment
3. Slower economic
growth
Shortage
Demand
$190
$250 $300
Savings/borrowing
A Ceiling on Interest Rates Creates a Shortage of Savings
Politicized Lending
 In many countries, most large banks are owned
by the government.
 Government-owned banks are useful for
directing capital to political supporters.
 One study found that the larger the fraction of
government-owned banks a country had in
1970, the slower the growth in per capita GDP
and productivity over the next several decades.
 In the US, Countrywide Mortgage Company
made many “sweetheart” loans to Congress
55
Bank Failures and Panics
 At the onset of America’s Great Depression
between 1929 and 1933, almost half of all U.S.
banks failed.
 Many people lost their life savings.
 Spending decreased, which meant that many
businesses lost their customers and revenue.
 Businesses were unable to get loans or daily
working capital and therefore failed.
 It took many years before the American
economy recovered.
56
The Financial Crisis of 2007-2008
 Leading up to the crisis, Americans borrowed
more than ever.
 The borrowing was centered in the housing and
banking sectors.
 In the 1990s and 2000s, lenders became
convinced that house prices were unlikely to fall.
 They became willing to lend with much lower
down payments.
 At the height of the housing boom in 2006, 17%
of mortgages were made with 0% down.
57
Definition
Owner equity:
The value of the asset minus the debt,
or E = V − D.
Leverage ratio:
The ratio of debt to equity, or D/E.
58
The Financial Crisis of 2007-2008
Leverage
 A house worth $400,000 with 20% down and a
mortgage of $320,000:
Equity = $400,000 - $320,000 = $80,000
Leverage ratio = $320,000 / $80,000 = 4
 A house worth $400,000 with 10% down and a
mortgage of $360,000:
Equity = $400,000 - $360,000 = $40,000
Leverage ratio = $360,000 / $40,000 = 9
59
The Financial Crisis of 2007-2008
Securitization
 The seller of a securitized asset gets cash.
 The buyer gets a stream of future payments.
 Mortgage loans were “securitized,” or bundled
together and sold as financial assets.
 Bad loans were dumped on unsuspecting
investors around the world.
60
The Financial Crisis of 2007-2008
Securitization
 Housing prices started to fall in 2007.
 Many owners owed more on their mortgage
than their house was worth.
 Delinquency and foreclosure rates more than
doubled.
 Many banks and financial intermediaries ended
up with loans and assets of questionable value.
61
The Financial Crisis of 2007-2008
Shadow Banking
 Traditional banks fund themselves largely
through deposits.
 These deposits are insured by the Federal
Deposit Insurance Corporation (FDIC).
 Shadow banking includes investment banks,
hedge funds, money market funds, and others.
 Investment banks are funded by investors and
are not insured by the FDIC.
62
The Financial Crisis of 2007-2008
 The shadow banking
system is less heavily
regulated and monitored
than traditional banks.
 For years, regulators and
policymakers were
Lehman Brothers declared
bankruptcy in 2008.
unaware of its importance.
 At its peak in 2008 the shadow banking system
lent $20 trillion, considerably more than did
traditional banks.
OLI SCARFF/GETTY IMAGES
63
The Financial Crisis of 2007-2008
The Crisis
 As house prices fell, highly leveraged home owners
defaulted on their mortgages.
 Highly leveraged banks were pushed towards
insolvency.
 It wasn’t always clear who owned what or who
faced the worst losses.
 Investors became unwilling to extend short-term
funding to shadow banks.
 Credit markets froze up - WAFD
 ("We're all freaking doomed.")
64
The Financial Crisis of 2007-2008
 The government has taken steps to avoid this
happening again.
 After the Lehman Brothers failure, the Federal
Reserve took over AIG when it was failing and
guaranteed its debts.
 New financial regulations are bringing the
shadow banking system “out of the shadows”.
 Banks of all kinds are required to hold more
equity, reducing the amount of their leverage.
65
Self-Check
Banks that are funded by investors and are not
insured by the FDIC are called:
a. Traditional banks.
b. Commercial banks.
c. Shadow banks.
Answer: c – shadow banks.
66
Takeaway
 Saving and borrowing allow individuals, firms,
and governments to smooth their consumption
over time.
 Financial intermediaries bridge the gap between
savers and borrowers.
 Financial intermediaries also collect savings,
evaluate investments, diversify risk, and help
finance new and innovative ideas.
67
Takeaway
 Insecure property rights, inflation, politicized
lending, and bank failures and panics can all
contribute to the breakdown of financial
intermediation.
 The 2007–2008 crisis was brought about by
high leverage and falling asset prices that
created a panic and sharply reduced the
amount of lending in the economy.
68