Investment, Savings, and the Financial System

Types of Investment

In macroeconomics, investment refers to two distinct concepts: economic investment and financial investment. Economic investment involves the allocation of current resources to produce future output, typically carried out by firms. Financial investment refers to the purchase of financial assets, such as stocks or bonds, usually by households.

• Economic Investment: When current resources are devoted to increasing future output. Usually performed by firms.

• Financial Investment: The purchase of financial assets for future returns. Usually performed by households.

• Example: A factory purchasing new machinery (economic investment) versus a family buying shares in a mutual fund (financial investment).

Savings and Its Role

Savings occur when current consumption is less than current output. Households are the primary source of savings in the economy. These savings are essential for firms to invest and grow, fueling long-term economic growth.

• Savings: The portion of income not spent on current consumption.

• Role: Provides funds for investment, enabling economic growth.

• Example: A family saving part of their income in a bank account.

The Financial System

The financial system consists of financial markets and intermediaries that connect savers and borrowers. It enables firms to access funds for investment and households to earn returns on their savings.

• Financial Markets: Platforms where savers directly supply funds to borrowers (e.g., stock and bond markets).

• Financial Intermediaries: Institutions (e.g., banks, mutual funds) that channel funds from savers to borrowers.

• Example: A bank lending money to a business for expansion.

National Savings and Investment

Savings Equals Investment Identity

In macroeconomics, total savings must equal total investment for an economy. This relationship is fundamental to understanding how resources are allocated.

• Savings: Current consumption is less than current output.

• Investment: Current resources are devoted to producing future output.

• Formula: (for an open economy)

• Closed Economy: (net exports NX = 0)

• Solving for Investment:

National Savings

National savings is the total income remaining after paying for consumption and government purchases. It can be broken down into private and public savings.

• Private Savings: Income left after paying for consumption and taxes.

• Public Savings: Government tax revenue left after spending.

• Formula:

• National Savings:

Budget Surplus and Deficit

• Budget Surplus: When government tax revenue exceeds spending.

• Budget Deficit: When government tax revenue is less than spending.

Open Economy and Net Capital Inflow

In an open economy, international trade affects the savings-investment identity. Net Capital Inflow (NCI) represents investment spending financed by funds borrowed from foreigners.

• Formula:

• Investment in Open Economy:

The Market for Loanable Funds

Supply and Demand for Loanable Funds

The market for loanable funds uses a supply-and-demand model to determine the equilibrium interest rate. Households supply loanable funds through savings, while firms and government demand funds for investment.

• Supply: Comes from households with savings.

• Demand: Comes from firms and government making economic investments.

• Interest Rate: The cost of borrowing funds, expressed as a percentage.

• Example: Borrowing $100,000 and repaying $105,000 (interest rate = 5%).

Shifts in the Market for Loanable Funds

Shifts in demand and supply for loanable funds are influenced by changes in business opportunities, tax rates, savings incentives, and government budget positions.

• Demand Shifts: Changes in expected future profits, corporate tax rates, and government borrowing needs.

• Supply Shifts: Changes in household savings incentives (e.g., tax benefits), and government budget surplus or deficit.

Stocks, Bonds, and Mutual Funds

Bonds

Bonds are financial securities representing promises to repay a fixed amount of funds. They are considered relatively safe investments, and bondholders are repaid before other stakeholders during bankruptcy.

• Principal: The loan amount.

• Interest Rate: The rate paid on the bond.

• Maturity Date: The date the bond must be repaid.

Stocks

Stocks represent partial ownership of a firm. Shareholders are entitled to a portion of profits, which may be paid as dividends or retained for future projects. Stocks do not have a maturity date.

• Dividends: Payments to shareholders.

• Capital Gains: Increases in stock value over purchase price.

Mutual Funds

Mutual funds are institutions that sell shares to the public and use the money to create a diversified portfolio. They can be actively or passively managed.

• Diversification: Reducing risk by holding a variety of investments.

• Actively Managed: Portfolio managers buy and sell stocks frequently.

• Passively Managed: Funds follow a stock index and hold more constant portfolios.

Risk, Insurance, and Diversification

Risk and Insurance

Risk is the uncertainty regarding future gains or losses. People are generally risk-averse, preferring to avoid losses more than they enjoy gains. Insurance protects against unlikely but catastrophic losses.

• Utility: Measurement of satisfaction.

• Marginal Utility: Additional satisfaction from consuming more of a good.

• Law of Diminishing Returns: Marginal utility decreases as consumption increases.

Diversification, Firm-Specific Risk, and Market Risk

Diversification reduces risk by holding a variety of investments. Firm-specific risk affects only one company and can be diversified away. Market risk affects the entire market and cannot be diversified.

• Riskier investments: Must pay a higher rate of return.

• Risk-free rate: Return on an investment with no risk (e.g., government bonds).

• Efficient Market Hypothesis: Asset prices reflect all publicly available information.

• Random Walk: Asset price changes are unpredictable.

Time Value of Money

Compounding and Discounting

The Time Value of Money (TVM) concept states that a dollar today is worth more than a dollar tomorrow. Compounding calculates future value from present value, while discounting finds present value from future value.

• Future Value (FV):

• Present Value (PV):

• r: Interest rate (decimal)

• n: Number of periods

• Example: Investing FV = 100 \times (1.1)^3$

Calculating Bond and Stock Prices

Bond Pricing

The value of a bond is the present value of its future cash flows, including interest payments and principal repayment.

• Bond Price Formula:

Stock Pricing

The value of a stock is the present value of expected future dividends, assuming dividends grow at a constant rate.

• Stock Price Formula:

• i: Discount rate

• g: Dividend growth rate

• Example: If dividend = Stock\ Price = \frac{1}{0.08 - 0.05} = 33.33$