Lecture 29

The financial system is the group of institutions that helps match the savings of one person with the investments of another.
Financial markets are institutions through which savers can directly provide funds to borrowers. For example,

• The bond market. A bond is a certificate of indebtedness. When someone purchases a bond, they receive some interest on it regularly, until the loan is repaid at the date of maturity. Bonds that never mature are said to be a perpetuity. Income taxes are not paid on municipal bonds, which are bonds issued by the local/state government.
• The stock market. A stock is a claim to partial ownership in a firm. When someone purchases a stock, they receive part of the profits. These tend to be higher risk and higher reward than bonds.

Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers. The two main ones are

• banks, which take in deposits from people who want to save and loan it to people who want to borrow, and
• mutual funds, which are institutions that sell shares to the public and use the proceeds to buy selections (portfolios) of stocks and bonds.

Private savings refers to the portion of a household’s income that is not used for consumption or paying taxes.
Public savings refer to the tax revenues minus the government spendings.
National savings is the sum of the private savings and public savings. This is equal to

\[(\text{Y} - \text{T} - \text{C}) + (\text{T} - \text{G}) = \text{Y} - \text{C} - \text{G},\]

where \(\text{Y}\) is the yearly income, \(\text{T}\) is the taxes paid minus the amount it pays back in transfer payments, \(\text{C}\) is the consumption, and \(\text{G}\) is the government purchases. This is the portion of the national income that is used for neither consumption nor government purchases.
Consider a closed economy with \(\text{NX} = 0\). Then the GDP is equal to \(\text{C} + \text{I} + \text{G}\), so the investment is equal to the national savings.

The budget surplus is the excess of tax revenue over government purchases (this is equal to the public savings). The budget deficit is the opposite (the negative of the public savings).

Investment is the purchase of new capital – it is not just the purchase of stocks and bonds! It is anything that will give future returns.

The supply of loanable funds comes from savings and the demand for loanable funds comes from investment. Households with extra income can loan it out to earn interest. Public savings, if positive, add to national savings and the supply of loanable funds.
An increase in interest rate makes saving more attractive, which increases the quantity of loanable funds supplied. This reduces the demand for loanable funds, however. As in microeconomics, the interest rate adjusts to equate supply and demand.
Incentives to encourage savings (a policy to shield some savings from taxation for example) increase the supply of loanable funds, which reduces the equilibrium interest rate and increases the equilibrium quantity of loanable funds. A government budget deficit would do the opposite.
Investment incentives (an investment tax credit for example) raise the equilibrium interest rate and reduce the equilibrium quantity of loanable funds.
A budget deficit causes a fall in the supply of loanable funds, which raises the equilibrium interest rate. The government borrows to finance its deficit, leaving less funds available for investment. This is known as crowding out, and reduces the economy’s growth rate and future standards of living.
A budget surplus would do the opposite.
It should be noted that the interest rate we are talking about above is the real rate, which is the nominal interest rate corrected for inflation. <!– The financial institution is the group of institutions that helps match the savings of one person with the investments of another.
Financial markets are institutions through which savers can directly provide funds to borrowers. For example,

• The bond market. A bond is a certificate of indebtedness.
• The stock market. A stock is a claim to partial ownership in a firm. Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers. For example, banks and mutual funds (institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds).
  Private savings refers to the portion of a household’s income that is not used for consumption or paying taxes.

National savings is the sum of the private savings and public savings. This is equal to

\[(\text{Y} - \text{T} - \text{C}) + (\text{T} - \text{G}) = \text{Y} - \text{C} - \text{G},\]

where \(\text{Y}\) is the yearly income, \(\text{T}\) is the taxes paid, \(\text{C}\) is the consumption, and \(\text{G}\) is the government purcahses. This is the portion of the national income that is used for neither consumption nor government purchases.
Consider a closed economy case with \(\text{NX} = 0\). Then the GDP is equal to \(C + I + G\). Therefore, \(I\) is equal to the national savings in a closed economy.

A budget surplus is the excess of tax revenue over government purchases. A budget deficit is the opposite.

Investment is the purchase of new capital – it is not just the purchase of stocks and bonds! It is anything that will give future returns.

The supply of loanable funds comes from savings. Households with extra income can loan it out to earn interest. Public savings, if positive, add to national savings and the supply of loanable funds. An increase in interest rate makes saving more attractive, which increases the quantity of loanable funds supplied. This reduces the demand for loanable funds, however. As in microeconomics, the interest rate adjusts to equate supply and demand.

An increase in budget deficit causes a fall in investment. The government borrows to finance its deficit, leaving less funds available for investment. This is known as crowding out.

Money is the yardstick with which we measure economic transactions and debts. –>