EC 111, Week 6 Notes
EC 111, Week 6 Notes Econ 111
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This 3 page Class Notes was uploaded by Matt Cutler on Friday February 26, 2016. The Class Notes belongs to Econ 111 at University of Alabama - Tuscaloosa taught by Kent 0. Zirlott in Fall 2016. Since its upload, it has received 26 views.
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Date Created: 02/26/16
Financial Institutions Wednesday, February 24, 2016 3:49 PM • The financial system: the group of institutionsthat helps match the savings of one person with the investment of another • Financial Markets: institutionsthrough which savers can directly provide funds to barrowers. ○ Ex: The bond market A bond is a certificate of indebtedness ○ Ex: The stock market A stock is a claim of partial ownership in a firm • Financial Intermediaries:institutionsthrough which savers can indirectly provide funds to borrowers ○ Ex: Banks Mutual Funds- institutionsthat sell shares to the public and use the proceeds to buy portfoliosof stocks and bonds • Private Saving ○ The portion of household'sincome that is not used for consumption or paying taxes = Y- T- C (Y= income) • Public Saving ○ Tax revenue less government spending =T-G ( T= taxes, G= investment or govt spending • National saving ○ Private saving + Public Saving =(Y- T- C) + ( T-G) □ = Y-C-G ○ The portion of national income that is not used for consumption or government purchases • Saving = investment in a closed economy • Budget Surplus ○ An excess of tax revenue over govt spending ○ T-G ○ Public Saving • Budget Deficit ○ A shortfall of tax revenue from govt spending ○ G-T ○ Find public Savings= -(Budget deficit) 1. The meaning of Saving and Investment a. Private saving is the income remaining after householdspay their taxes and pay for consumption i. Ex of what householdsdo with saving: 1) Buy corporate bonds or equities 2) Purchase a certificate of deposit at the bank 3) Buy shares of a mutual fund 4) Let accumulate in saving or checking accounts b. Investment is the purchase of new capital b. Investment is the purchase of new capital i. Ex: 1) General motors spends $250 million to build a new factory in Flint, Michigan 2) You buy $5000 worth of computer equipmentfor your business 3) Your parents spend $300,000 to have a new house built 2. The Market for Loanable Funds a. A supply-Demand model of the financial system i. Assume: only one financial market 1) All savers deposit their savings in this market 2) All borrowers take out loans from this market. 3) There is one interest rate, which is both the return to saving and the cost of borrowing. b. The Supply of loanable funds comes from saving: i. Households with extra income can loan it out and earn interest ii. Public saving, if positive, adds to national saving and the supply of loanable funds. 1) If Negative, it reduces national saving and the supply of loanable funds. iii. The slope of the supply curve (with interest rate as and loanable funds as the axes) slopes upward because at a higher interest rate, it makes saving more attractive. c. The Demand for loanable funds comes from investments: i. Firms borrow the fundsthey need to pay for new equipment,factories, etc. ii. Households borrow the funds they need to purchase new houses. iii. Slopes downward 1) Because more people are more likely to borrow money at lower interest rates. d. Equilibrium i. Real interest rates equal the supply and demand of loanable funds. ii. Savings incentives 1) Cutting taxes, tax incentives for saving, increases the supply of loanable funds. 2) Decreases interest rate iii. Investment incentives 1) Investment tax credit increases the demand for Loanable funds. 2) Interest rate rises iv. Other factors that will shift savings or investment 1) Savings a) Changes in income b) Expectations Government Budget Deficit reduces national saving and the supply of loanable funds. Causes interest rate to rise and investment to decrease. 2) Investment a) Technological Progress (Shifts demand curve, because when new technology comes out, businesses must keep up) b) Expectations 3) Budget Deficit, Crowding out, and Long run Growth a) Our analysis: increase in budget deficit causes fall in investment. The govt borrows to finance its deficit, leaving less funds available The govt borrows to finance its deficit, leaving less funds available for investment b) This is called crowding out. c) Recall from the preceding chapter: investment is important for long-run economic growth. Hence, budget deficits reduce the economy's growth rate and future standard of living. v. The Government Debt. a) The government finances deficits by borrowing (Selling government bonds) b) Persistent deficits lead to a rising govt debt. c) The ratio of govt debt to GDP is a useful measure of the government's indebtednessrelative to its ability to raise tax revenue d) Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime- until the early 1980s vi. Conclusion 1) Like many other markets, financial markets are governed by the forces of supply and demand 2) One of the Ten Principles from Chapter 1: a) Markets are usually a good way to organize economic activity b) Financial markets help allocate the economy's scarce resources to their most efficient uses. 3) Financial markets also link the present to the future: They enable savers to convert current income into future purchasing power, and borrowers to acquire capital to produce goods and services in the future.
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