The Financial System

Overview of the Financial System

The financial system is a network of institutions that facilitates the flow of funds from savers to borrowers, enabling investment and economic growth. It consists of financial markets and financial intermediaries, each playing a distinct role in channeling savings into productive investments.

• Financial markets: Institutions where savers directly provide funds to borrowers. Examples include the bond market and the stock market.

• Financial intermediaries: Institutions where savers indirectly provide funds to borrowers. Examples include commercial banks and mutual funds.

Financial Markets

The Bond Market

The bond market allows entities to borrow funds by issuing bonds, which are certificates of indebtedness. Bonds are characterized by several key features:

• Date of maturity: The date when the loan is repaid.

• Yield (interest rate): The return paid to bondholders.

• Principal: The amount originally borrowed.

• Term: Length of time until maturity (e.g., perpetuity).

• Credit risk: Probability that the borrower will default.

• Tax treatment: How tax laws treat interest income (e.g., municipal bonds may be tax-exempt).

The Stock Market

The stock market enables firms to raise capital by selling shares, which represent partial ownership. Stocks entitle owners to a share of the firm's profits.

• Equity finance: Raising capital by selling stock.

• Debt finance: Raising capital by selling bonds.

• Risk and return: Stocks generally offer higher risk and higher average returns compared to bonds.

• Stock exchanges: After an IPO, shares are traded on organized exchanges (e.g., NYSE, NASDAQ).

Reading Stock Tables: Key numbers to track:

• Price: Cost of a single share.

• Dividend: Share of profits paid to stockholders.

• PE Ratio: Price divided by earnings per share.

Stock tables are available online (e.g., Bloomberg).

Financial Institutions

Financial Intermediaries

Financial intermediaries facilitate indirect lending and borrowing. They include:

• Commercial banks: Accept deposits and lend funds, reducing search and monitoring costs, and creating a medium of exchange.

• Mutual funds: Sell shares to the public and use proceeds to buy a diversified portfolio of stocks and bonds, allowing savers to diversify.

Saving: Types and Formulas

Private and Public Saving

Saving is the portion of income not used for consumption or taxes. It is classified as:

• Private saving: Income remaining after households pay taxes and consume.

• Public saving: Tax revenue less government spending.

Formulas:

• Private saving:

• Public saving:

Budget Deficits and Surpluses

• Budget surplus: Excess of tax revenue over government spending ().

• Budget deficit: Shortfall of tax revenue from government spending ( or ).

National Saving

National saving is the sum of private and public saving, representing the portion of national income not used for consumption or government purchases.

• National saving:

Saving and Investment

National Income Accounting Identity

The national income accounting identity relates output to its uses:

• In a closed economy (no net exports):

• Solve for investment:

• Thus, in a closed economy, saving equals investment.

Examples of Saving and Investment

• Saving: Buying bonds, equities, certificates of deposit, mutual fund shares, or accumulating funds in accounts.

• Investment: Purchase of new capital (e.g., building a factory, buying equipment, constructing a house).

• Note: In economics, investment refers to new capital, not the purchase of stocks and bonds.

The Market for Loanable Funds

Model Overview

The market for loanable funds is a supply–demand model that explains how saving and investment are coordinated and how interest rates are determined.

• All savers deposit funds; all borrowers take loans.

• One interest rate: return to saving and cost of borrowing.

Supply and Demand in the Loanable Funds Market

• Supply: Comes from saving (households and public saving).

• Demand: Comes from investment (firms and households).

Slope of Supply Curve: Higher interest rates make saving more attractive, increasing the quantity supplied.

Slope of Demand Curve: Lower interest rates reduce borrowing costs, increasing the quantity demanded.

Equilibrium

The interest rate adjusts to equate supply and demand. The equilibrium quantity of loanable funds equals equilibrium investment and saving.

Policy Effects on Loanable Funds Market

Policy 1: Saving Incentives

• Tax incentives for saving increase supply of loanable funds.

• Result: Lower equilibrium interest rate, higher equilibrium quantity.

Policy 2: Investment Incentives

• Investment tax credits increase demand for loanable funds.

• Result: Higher equilibrium interest rate, higher equilibrium quantity.

Policy 3: Government Budget Deficits

• Budget deficits reduce national saving and supply of loanable funds.

• Result: Higher equilibrium interest rate, lower equilibrium quantity.

Budget Deficits, Crowding Out, and Long-Run Growth

Crowding Out Effect

When the government runs a budget deficit, it borrows from the loanable funds market, reducing funds available for private investment. This is known as crowding out.

• Reduced investment leads to slower long-run economic growth.

• Lower future standard of living due to decreased capital formation.

Sample Calculation: Saving and Investment

Example Problem

Suppose GDP () = $10C trillion, government spending () = $2G - T trillion.

• Public saving: trillion

• Taxes: trillion

• Private saving: trillion

• National saving: trillion

• Investment: trillion

Summary Table: Types of Saving

Summary Table: Policy Effects on Loanable Funds Market

Additional info: Academic context and formulas have been expanded for clarity and completeness. Tables have been reconstructed to summarize key relationships and policy effects.