İktisada Giriş II Saving Investment CHAPTER 4: SAVING, INVESTMENT AND THE FINANCIAL SYSTEMFunction of the Financial System The financial system consists of the group of ? institutions in the economy that perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds. Promotes economic efficiency by producing ? an efficient allocation of capital, which increases production. Improve the well-being of consumers by ? allowing them to time purchases better.FINANCIAL INSTITUTIONS The financial system is made up of ? financial institutions that matches savers and borrowers. Financial institutions can be grouped into ? two different categories: Financial markets ? Financial intermediaries ?FINANCIAL INSTITUTIONS Financial markets are arrangements ? (location or medium) where savers can directly provide funds to borrowers. Financial intermediaries are financial ? institutions which collect funds from savers and lend to borrowers. They “intermediate” between savers and borrowers. FINANCIAL INSTITUTIONS Financial Markets ? Stock Market: Share of ownership in a firm. ? Firms borrow money from savers who buy their shares. Bond Market: Debt instrument. Government ? and firms issue bonds to borrow money from savers who buy these bonds. FINANCIAL INSTITUTIONS Financial Intermediaries ? Institutions that accept deposits : Banks ? Investment Intermediaries: Investment Funds ? (collects savings and manages a portfolio of securities on owners ’ behalf). Careful with the “investment” word! Contractual Savings Institutions: Life ? Insurance, Fire & Casualty Insurance, Pension Funds, Government Retirement Funds.Financial Markets The Bond Market ? A bond is a debt instrument that specifies ? obligations of the borrower (issuer) to the holder (owner) of the bond. Characteristics of a Bond ? Face Value: Nominal YTL value to be repaid at the ? date of maturity. Date of Maturity: The time at which the face value ? will be repaid.Financial Markets Types of Bonds: ? Discount Bond: Current price is smaller than ? face value, sold at a discount. Ex: Treasury discount bond with 1000 YTL face value and one year maturity is sold for 900 YTL. then the interest rate will be (1000-900) / 900 = 11.1 %Financial Markets Types of Bonds (continued): ? Coupon Bond: Issuer of this bond makes fixed ? interest payments to the holder every year until the maturity date. Ex: A coupon bond with 1000 YTL face value, 50% coupon rate, annual coupon payments and 5 years maturity issued by the Treasury. The treasury will pay you 500 YTL every year and will pay you 1500 YTL five years later. Financial Markets The Stock Market ? Stock represents a share of ownership in a ? firm. A share of stock is a claim on the earnings and assets of the corporation. Ex: If Turkcell has 1,000,000 total shares and you own 1 share, then you own 1/1,000,000 of Turkcell ’ s assets. Stocks pay “dividends ” to the shareholders ? regularly. Ex: every 6 months. Compared to bonds, stocks offer both higher ? risk and potentially higher returns. Tradeoff: risk-return.Financial Markets The Stock Market ? Both stocks and bonds are first issued in the ? primary market. This is when the issuer firm does initial public offering (IPO). After that, stocks are traded in the secondary market. Stock exchanges are the secondary markets. The stock exchange in Turkey: Istanbul Stock ? Exchange (ISE). In the United States: New York Stock Exchange, the American Stock Exchange, and NASDAQ. London, Frankfurt and Tokyo have large stock exchanges. Financial Intermediaries Financial intermediaries are financial ? institutions through which savers can indirectly provide funds to borrowers. Why do we need intermediaries? ? Small savers cannot buy stocks or bonds, or ? cannot diversify easily because of transaction costs. Small borrowers (firms) cannot issue stocks or ? bonds, so they borrow from banks. Intermediaries solve these problems. ? Economies of scale reduces transaction costs.Financial Intermediaries Banks… ? take deposits from people who want to save ? and use the deposits to make loans to people who want to borrow. pay depositors no interest (checking accounts) ? or some interest (savings accounts) on their deposits. charge borrowers higher interest on their ? loans. profit from the interest rate difference and ? fees for liquidity services. Financial Intermediaries Banks provide liquidity services by… ? allowing people to purchase goods and ? services using debit and credit cards. No need to carry cash. write checks against their checking account ? deposits. More common in the US. use internet to make purchases, money ? transfers, automatic bill payments, etc.Financial Intermediaries Investment (Mutual) Funds ? A mutual fund is an institution that sells ? shares to the public and uses the proceeds to buy a portfolio of various types of stocks and bonds. Mutual funds allow people with small amounts ? of money to easily diversify. They pool savings so that they can avoid transaction costs: economies of scale. SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS Recall that GDP is both total income in an ? economy and total expenditure on the economy ’ s output of goods and services: Y = C + I + G + NXSome Important Identities Assume a closed economy (as opposed to ? an open economy). A closed economy does not engage in international trade: NX = 0 Y = C + I + GSome Important Identities We define national saving of an ? economy as the total income in the economy that is left after paying for consumption and government purchases. If we subtract C and G from total income ? in the equation: Y – C – G = I We get national saving (S) on the left ? hand side.Some Important Identities Denoting saving by S, we get: ? S = I For a closed economy, saving equals ? investment.Some Important Identities We can divide national saving into two ? parts: private saving and public saving. Suppose T is the amount of tax revenues collected by the government. S = Y – C – G We can also write: ? S = (Y – T – C) + (T – G) National S. = Private S. + Public S.Some Important Identities Private Saving ? Private saving is the amount of income that ? households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C) ?Public Saving ? Public saving is the amount of tax revenue ? that the government has left after paying for its spending. Public saving = (T – G) ? Some Important IdentitiesSurplus and Deficit ? If T > G, the government runs a budget ? surplus because it receives more money than it spends. The surplus of T - G represents public saving. ? If G > T, the government runs a budget ? deficit because it spends more money than it receives in tax revenue. In this case public saving is negative. This has been the case in Turkey in most of its history. Some Important IdentitiesThe Meaning of Saving and Investment For the (closed) economy as a whole, ? saving must be equal to investment. S = I For economists, investment refers to ? purchase of machinery, equipment and buildings. In everyday language, “investment ” is used to describe purchases of stocks and bonds. For us, those are acts of saving. THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the ? economy ’ s saving and investment in the market for loanable funds. The market for loanable funds is the ? market in which those who save supply funds and those who borrow demand funds.Figure 1 The Market for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply Demand 5% $1,200Supply and Demand for Loanable Funds Loanable funds refers to all income that ? people have chosen to save and lend out, rather than use for their own consumption. The supply of loanable funds comes from ? people who have extra income they want to save and lend out. The demand for loanable funds comes ? from firms and households that wish to borrow to make investments.Supply and Demand for Loanable Funds Interest rate ? Is the price of the loan (credit) ? Is the amount that borrowers pay for loans ? and the amount that lenders earn on their saving in the market for loanable funds, we use the ? real interest rate. Ignore inflation.Supply and Demand for Loanable Funds Financial markets work much like other ? markets in the economy. The equilibrium of the supply and demand ? for loanable funds determines the real interest rate.Supply and Demand for Loanable Funds Government Policies That Affect Saving ? and Investment Taxes on saving (interest earnings). ? Taxes on investment expenditures. ? Government budget deficits and surpluses. ?Policy 1: Saving Incentives Taxes on interest income substantially ? reduce the future payoff from current saving and, as a result, reduce the incentive to save. A tax cut on interest earnings increases ? the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts ? right. The equilibrium interest rate decreases. ? Amount of investment increases. ?Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply, S 1 S 2 2. . . . which reduces the equilibrium interest rat e . . . 3. . . . and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable fund s . . . 5% $1,200 4% $1,600Policy 1: Saving Incentives If a change in tax law encourages greater ? saving, the result will be lower interest rates and greater saving and investment.Policy 2: Investment Incentives An investment tax credit increases the ? incentive to borrow. Increases the demand for loanable funds. ? Shifts the demand curve to the right. ? Results in a higher interest rate and a ? greater quantity saved and invested.Figure 3 Investment Incentives Increase the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An investment tax credit increases the demand for loanable fund s . . . 2. . . . which raises the equilibrium interest rate . . . 3. . . . and raises the equilibrium quantity of loanable funds. Supply Demand, D 1 D 2 5% $1,200 6% $1,400Policy 2: Investment Incentives If a change in tax laws encourages greater ? investment, the result will be higher interest rates and greater saving and investment.Policy 3: Government Budget Deficits and Surpluses When the government spends more than it ? receives in tax revenues, the short fall (G - T) is called the budget deficit (flow concept). Government borrows to finance its deficit. ? Issues and sells bonds in the bond market. The accumulation of past budget deficits is ? called the government debt (stock concept). Policy 3: Government Budget Deficits and Surpluses Government borrowing to finance its ? budget deficit reduces the supply of loanable funds available to finance investment by firms. This fall in investment is referred to as ? crowding out. This has been especially big problem for Turkey. The deficit borrowing crowds out private ? borrowers who are trying to finance investments. Also keeps int. rate very high.Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of ? loanable funds. Shifts the supply curve to the left. ? Increases the equilibrium interest rate. ? Reduces the equilibrium quantity of ? loanable funds.Figure 4: The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate 3. . . . and reduces the equilibrium quantity of loanable funds. S 2 2. . . . which raises the equilibrium interest rat e . . . Supply, S 1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable fund s . . .Policy 3: Government Budget Deficits and Surpluses When government reduces national saving ? by running a deficit, the interest rate rises and investment falls. A budget surplus increases the supply of ? loanable funds, reduces the interest rate, and stimulates investment.Figure 5 The U.S. Government Debt Percent of GDP 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 Revolutionary War 2010 Civil War World War I World War II 0 20 40 60 80 100 120T u r k e y ' s F o r e i g n D e b t / G N P S o u r c e : C B R T , T r e a s u r y 0 , 0 1 0 , 0 2 0 , 0 3 0 , 0 4 0 , 0 5 0 , 0 6 0 , 0 7 0 , 0 8 0 , 0 9 0 , 0 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4