Econ 2 Lecture 4 Notes (Chapter 26)
Econ 2 Lecture 4 Notes (Chapter 26) ECON 2
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This 5 page Class Notes was uploaded by Anna on Saturday October 15, 2016. The Class Notes belongs to ECON 2 at University of California - Los Angeles taught by Rojas in Fall 2016. Since its upload, it has received 5 views.
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Date Created: 10/15/16
Lecture 4: Saving, Investment, and the Financial System 1. Financial Institutions a. Financial system - a group of institutions that helps match the saving of one person with the investment of another i. Ex: the Fed, Wall Street, credit unions b. Financial markets - institutions through which savers can directly provide funds to borrowers i. Bond market - bond is certificate of indebtedness, IOU’s ○ Less risky → lower returns (ex: U.S. Treasury) ○ More risky → higher returns (ex: corporate bond) ○ Lending money ii. Stock market - claim to partial ownership of firm ○ Buy shares of a company ○ More risky than bond market → higher returns than bond market c. Financial intermediaries - institutions through which savers can indirectly provide funds to borrowers i. Banks ii. Mutual funds - institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds 2. Elements of Financial Crisis a. Large decline in some asset prices i. 2008-2009: Housing prices fell 30% b. Insolvencies at financial institutions i. 2008-2009: Banks and other institutions failed when many homeowners stopped paying their mortgages c. Decline in confidence in financial institutions i. 2008-2009: Customers with uninsured deposits began pulling their funds out of financial institutions d. Credit crunch i. 2008-2009: borrowers unable to get loans because troubled lenders not confident in borrowers’credit worthiness e. Economic downturn i. Failing financial institutions and a fall in investment caused GDP to fall and unemployment to rise f. Vicious circle Downturn reduced profits and asset values → worsen crisis i. g. Consumers stop spending → demand for goods/service decrease → producers cut production → layoff → unemployment h. Solve by putting money into economy, make borrowing more attractive → lower interest rates i. Economy doing well - interest rates go up ii. Lower interest rate to get out of recession ○ Have to be very careful because right now we are close to 0, very fragile → if hit with another recession → collapse iii. What could cause another recession ○ Decrease in spending ○ Too much borrowing from foreign countries ○ Hedge funds ○ Student loans iv. Market solution for economy to recover ○ Increase interest rate -- hyperinflation i. Velocity of money i. How often dollar changes hands ○ Drops when in recession 3. Different Kinds of Saving a. Private saving - portion of households’income that is not used for consumption or paying taxes i. Y - T - C ○ Y = GDP; T = taxes; C = consumption b. Public saving - tax revenue less government spending i. T - G ○ G = government spending c. National saving - portion of national income that is not used for consumption or government purchases i. private saving + public spending ii. (Y - T - C) + (T - G) = Y - C - G 4. Saving and Investment a. National income accounting identity: Y = C + I + G + NX b. For rest of chapter, focus on closed economy (no exports) - NX = 0 c. National saving = investment (in closed economy) i. Y = C + I + G → I = Y - C - G 5. Budget Deficits and Surpluses Budget surplus - an excess of tax revenue over government spending a. i. T - G ii. Positive value for public spending iii. Make lending more affordable, build infrastructure b. Budget deficit - shortfall of tax revenue from government spending i. G - T ii. Negative value for public spending iii. Cuts, borrowing from abroad c. Ex: how a tax cut affects saving -- government cut taxes by $200 billion i. Tax cut → increase consumer spending, decrease government revenue ii. Scenario #1: Consumers save full proceeds of tax cut ○ Consumers save full $200 billion → National saving unchanged → investment unchanged iii. Scenario #2: Consumers save ¼ of tax cut and spend the other ¾ ○ Save $50 billion and spend $150 billion → National saving and investment each fall by $150 billion iv. Both scenarios - public saving falls by $200 billion, budget deficit rise from $300 billion to $500 billion v. Which of these two scenarios do you think is more realistic? ○ Scenario #2 - spending 6. The Meaning of Saving and Investment a. Private saving - income remaining after households pay their taxes and pay for consumption i. Buy corporate bonds/equities ii. Purchase certificate of deposit at bank iii. Buy shares of mutual fund iv. Let accumulate in saving or checking account -- not good idea because of inflation b. Investment - purchase of new capital i. Build new factory ii. Buy equipment for business iii. Buy new house iv. Need to remember demand side of market 7. The Market for Loanable Funds a. Supply-demand model of financial system b. Help us understand i. How financial system coordinates saving and investment ii. How government policies and other factors affect saving, investment, interest rate c. Assume: only one financial market i. All savers deposit saving in this market ii. All borrowers take out loans from this market iii. There is one interest rate, both return to saving and cost of borrowing d. 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 supply of loanable funds ○ If negative, reduces national saving and supply of loanable funds e. Demand of loanable funds comes from investment i. Firms borrow the funds they need to pay for new equipment, factories, etc ii. Households borrow funds needed to purchase new houses 8. The Slope of the Supply Curve a. Increase in interest rate → saving more attractive → increase in quantity of loanable funds supplied 9. The Slope of the Demand Curve a. Decrease in interest rate → reduce cost of borrowing → increase quantity of loanable funds demanded 10. Equilibrium a. Interest rate adjusts to equate supply and demand b. Departure from equilibrium -- shortage or surplus, adjust c. Policy 1: Saving Incentives i. Tax incentives for saving increase supply of loanable funds (L.F) → reduced equilibrium interest rate and increase equilibrium quantity of L.F. d. Policy 2: Investment Incentives i. Investment tax credit increase demand for L.F (demand curve shift right) → raises equilibrium interest rate and increase equilibrium quantity of L.F e. Example: Budget Deficit i. Budget deficit → reduce national saving → supply curve shift left→ increase interest rate and decrease quantity of L.F./investment ii. Increase in budget deficit → fall in investment iii. Crowding out - Government borrows to finance debts → less funds available for investment ○ Investment important for long-run economic growth → budget deficit reduce economy’s growth rate and future standard of living 11. U.S. Government Debt a. Government finances deficits by borrowing (selling government bonds) b. Persistent deficits lead to rising government debt c. Ratio of government debt to GDP is useful measure of government’s indebtedness relative to its ability to raise tax revenue d. Real concern - magnitude of debt 12. International Flows of Goods and Capital a. Until 1975, U.S. trade was relatively balanced b. After 1875, imports grew faster than exports, causing a trade deficit c. U.S. is big importer of consumer goods, capital goods, and industrial supplies d. U.S big exporter of capital goods and industrial supplies
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