CHAPTER 4: SAVING, INVESTMENT AND THE FINANCIAL SYSTEM.

CHAPTER 4: CHAPTER 4: SAVING, INVESTMENT AND SAVING, INVESTMENT AND

THE FINANCIAL SYSTEMTHE FINANCIAL SYSTEM

Function of the Financial Function of the Financial SystemSystem

The The financial systemfinancial system consists of the group of consists of the group of institutions in the economy that perform the institutions in the economy that perform the essential function of channeling funds from essential function of channeling funds from economic players that have saved surplus economic players that have saved surplus funds to those that have a shortage of funds.funds to those that have a shortage of funds.

Promotes economic efficiency by producing Promotes economic efficiency by producing an efficient allocation of capital, which an efficient allocation of capital, which increases production. increases production.

Improve the well-being of consumers by Improve the well-being of consumers by allowing them to time purchases better.allowing them to time purchases better.

FINANCIAL INSTITUTIONSFINANCIAL INSTITUTIONS

The financial system is made up of The financial system is made up of financial institutions that matches financial institutions that matches savers and borrowers.savers and borrowers.

Financial institutions can be grouped Financial institutions can be grouped into two different categories: into two different categories: Financial marketsFinancial markets Financial intermediariesFinancial intermediaries


Financial marketsFinancial markets are are arrangements arrangements (location or medium) where (location or medium) where savers savers can directly provide funds to can directly provide funds to borrowers.borrowers.

Financial intermediariesFinancial intermediaries are financial are financial institutions which institutions which collect collect funds from funds from savers savers and lendand lend to borrowers. They to borrowers. They “intermediate” between savers and “intermediate” between savers and borrowers. borrowers.

FINANCIAL INSTITUTIONSFINANCIAL INSTITUTIONS Financial MarketsFinancial Markets

Stock Market: Share of ownership in a Stock Market: Share of ownership in a firm. Firms borrowfirm. Firms borrow money from savers money from savers who buy their shareswho buy their shares..

Bond Market: Debt instrument. Bond Market: Debt instrument. Government and firms issue bonds to Government and firms issue bonds to borrowborrow money from savers who buy money from savers who buy these bondsthese bonds. .


Financial IntermediariesFinancial Intermediaries Institutions that accept deposits : BanksInstitutions that accept deposits : Banks Investment Intermediaries: Investment Investment Intermediaries: Investment

Funds (collects savings and manages a Funds (collects savings and manages a portfolio of securities on owners’ behalf). portfolio of securities on owners’ behalf). Careful with the “investment” word!Careful with the “investment” word!

Contractual Savings Institutions: Life Contractual Savings Institutions: Life Insurance, Fire & Casualty Insurance, Insurance, Fire & Casualty Insurance, Pension Funds, Government Retirement Pension Funds, Government Retirement Funds.Funds.

Financial MarketsFinancial Markets

The Bond MarketThe Bond Market A A bondbond is a debt instrument that specifies is a debt instrument that specifies

obligations of the borrower (issuer) to the obligations of the borrower (issuer) to the holder (owner) of the bond. holder (owner) of the bond.

Characteristics of a BondCharacteristics of a Bond Face Value: Nominal YTL value to be repaid at Face Value: Nominal YTL value to be repaid at

the date of maturity.the date of maturity. Date of Maturity: The time at which the face Date of Maturity: The time at which the face

value will be repaid.value will be repaid.


Types of Bonds:Types of Bonds: Discount Bond: Current price is smaller Discount Bond: Current price is smaller

than face value, sold at a discount. Ex: than face value, sold at a discount. Ex: Treasury discount bond with 1000 YTL Treasury discount bond with 1000 YTL face valueface value and one year and one year maturitymaturity is sold is sold for 900 YTL. for 900 YTL. then the interest then the interest raterate will will be be

(1000-900) / 900 = 11.1 %(1000-900) / 900 = 11.1 %


Types of Bonds (continued):Types of Bonds (continued): Coupon Bond: Coupon Bond: Issuer of this bond makes Issuer of this bond makes

fixed interest payments to the holder every fixed interest payments to the holder every year until the maturity date.year until the maturity date. Ex: A Ex: A coupon coupon bond with 1000 YTL bond with 1000 YTL face valueface value,, 50% 50% coupon rate, coupon rate, annual annual coupon payments coupon payments and 5 years and 5 years maturitymaturity issued by the issued by the Treasury. The treasury will pay you 500 YTL Treasury. The treasury will pay you 500 YTL every year and will pay you 1every year and will pay you 15500 YTL five 00 YTL five years later. years later.

Financial Markets Financial Markets The Stock MarketThe Stock Market

StockStock represents a share of ownership in a firm. A represents a share of ownership in a firm. A share of stock is a claim on the earnings and share of stock is a claim on the earnings and assets of the corporation. Ex: If Turkcell has assets of the corporation. Ex: If Turkcell has 1,000,000 total shares and you own 1 share, then 1,000,000 total shares and you own 1 share, then you own 1/1,000,000 of Turkcell’s assets.you own 1/1,000,000 of Turkcell’s assets.

Stocks pay “dividends” to the shareholders Stocks pay “dividends” to the shareholders regularly. Ex: every 6 months.regularly. Ex: every 6 months.

Compared to bonds, stocks offer both higher risk Compared to bonds, stocks offer both higher risk and potentially higher returns. Tradeoff: risk-and potentially higher returns. Tradeoff: risk-return.return.

Financial Markets Financial Markets The Stock MarketThe Stock Market

Both stocks and bonds are first issued in the Both stocks and bonds are first issued in the primary marketprimary market. This is when the issuer firm . This is when the issuer firm does initial public offering (IPO). After that, does initial public offering (IPO). After that, stocks are traded in the stocks are traded in the secondary marketsecondary market. . Stock exchanges are the secondary markets.Stock exchanges are the secondary markets.

The stock exchange in Turkey: Istanbul Stock The stock exchange in Turkey: Istanbul Stock Exchange (ISE). In the United States: New Exchange (ISE). In the United States: New York Stock Exchange, the American Stock York Stock Exchange, the American Stock Exchange, and NASDAQ. London, Frankfurt Exchange, and NASDAQ. London, Frankfurt and Tokyo have large stock exchanges. and Tokyo have large stock exchanges.

Financial IntermediariesFinancial Intermediaries Financial intermediariesFinancial intermediaries are financial are financial

institutions through which savers can institutions through which savers can indirectly indirectly provide funds to borrowers.provide funds to borrowers.

Why do we need intermediaries? Why do we need intermediaries? Small savers cannot buy stocks or bonds, or cannot Small savers cannot buy stocks or bonds, or cannot

diversify easily because of diversify easily because of transaction coststransaction costs.. Small borrowers (firms) cannot issue stocks or Small borrowers (firms) cannot issue stocks or

bonds, so they borrow from banks. bonds, so they borrow from banks. Intermediaries solve these problems.Intermediaries solve these problems. Economies of Economies of

scale reduces transaction costs.scale reduces transaction costs.

Financial IntermediariesFinancial Intermediaries Banks…Banks…

take deposits from people who want to save take deposits from people who want to save and use the deposits to make loans to people and use the deposits to make loans to people who want to borrow.who want to borrow.

pay depositors no interest (checking accounts) pay depositors no interest (checking accounts) or some interest (savings accounts) on their or some interest (savings accounts) on their deposits.deposits.

charge borrowers higher interest on their loans.charge borrowers higher interest on their loans. profit from the interest rate difference and fees profit from the interest rate difference and fees

for liquidity services. for liquidity services.

Financial Intermediaries Financial Intermediaries

Banks provide liquidity services by…Banks provide liquidity services by… allowing people to purchase goods and allowing people to purchase goods and

services using debit and credit cards. No services using debit and credit cards. No need to carry cash.need to carry cash.

write checks against their checking write checks against their checking account deposits. More common in the account deposits. More common in the US.US.

use internet to make purchases, money use internet to make purchases, money transfers, automatic bill payments, etc.transfers, automatic bill payments, etc.

Financial IntermediariesFinancial Intermediaries

Investment (Mutual) FundsInvestment (Mutual) Funds A A mutual fundmutual fund is an institution that sells is an institution that sells

shares to the public and uses the shares to the public and uses the proceeds to buy a portfolio of various proceeds to buy a portfolio of various types of stocks and bonds.types of stocks and bonds.

Mutual funds allow people with small Mutual funds allow people with small amounts of money to easily amounts of money to easily diversifydiversify. . They pool savings so that they can avoid They pool savings so that they can avoid transaction costs: economies of scale. transaction costs: economies of scale.

SAVING AND INVESTMENT IN SAVING AND INVESTMENT IN THE NATIONAL INCOME THE NATIONAL INCOME

ACCOUNTSACCOUNTS

Recall that GDP is both total income Recall that GDP is both total income in an economy and total expenditure in an economy and total expenditure on the economy’s output of goods on the economy’s output of goods and services:and services:

YY = = CC + + II + + GG + + NXNX

Some Important IdentitiesSome Important Identities

Assume a Assume a closed economyclosed economy (as (as opposed to an opposed to an open economyopen economy). A ). A closed economy does not engage in closed economy does not engage in international trade: international trade: NX = 0NX = 0

YY = = CC + + II + + GG

Some Important IdentitiesSome Important Identities We define We define national savingnational saving of an economy of an economy

as the total income in the economy that is as the total income in the economy that is left after paying for consumption and left after paying for consumption and government purchases. government purchases.

If we subtract C and G from total income If we subtract C and G from total income in the equation:in the equation:

YY – – C C – – GG = = II We get national saving (We get national saving (SS) on the left hand ) on the left hand

side.side.


Denoting savingDenoting saving by by S,S, we get: we get:

SS = = II For a closed economy, saving equals For a closed economy, saving equals

investment.investment.


We can divide national saving into two We can divide national saving into two parts: parts: private savingprivate saving and and public savingpublic saving. . Suppose Suppose TT is the amount of tax is the amount of tax revenues collected by the government.revenues collected by the government.

SS = = YY – – CC – – GG We can also write:We can also write:

SS = ( = (YY – – TT – – CC) + () + (TT – – GG))

National S. = Private S. + Public S.National S. = Private S. + Public S.


Private SavingPrivate Saving Private savingPrivate saving is the amount of income is the amount of income

that households have left after paying that households have left after paying their taxes and paying for their their taxes and paying for their consumption.consumption.

Private saving = (Private saving = (YY – – TT – – CC) )

Public SavingPublic Saving Public savingPublic saving is the amount of tax is the amount of tax

revenue that the government has left revenue that the government has left after paying for its spending.after paying for its spending.

Public saving = (Public saving = (TT – – GG))


Surplus and DeficitSurplus and Deficit If If TT > > GG, the government runs a , the government runs a budget budget

surplussurplus because it receives more money than because it receives more money than it spends.it spends.

The surplus of The surplus of TT - - GG represents public saving. represents public saving. If If GG > > TT, the government runs a , the government runs a budget deficitbudget deficit

because it spends more money than it because it spends more money than it receives in tax revenue. In this case public receives in tax revenue. In this case public saving is negative. This has been the case in saving is negative. This has been the case in Turkey in most of its history.Turkey in most of its history.


The Meaning of Saving and The Meaning of Saving and InvestmentInvestment

For the (closed) economy as a whole, For the (closed) economy as a whole, saving must be equal to investment. saving must be equal to investment.

SS = = II For economists, For economists, investmentinvestment refers to refers to

purchase of machinery, equipment and purchase of machinery, equipment and buildings. In everyday language, buildings. In everyday language, “investment” is used to describe “investment” is used to describe purchases of stocks and bonds. For us, purchases of stocks and bonds. For us, those are acts of saving. those are acts of saving.

THE MARKET FOR THE MARKET FOR LOANABLE FUNDSLOANABLE FUNDS

Financial markets coordinate the Financial markets coordinate the economy’s saving and investment in economy’s saving and investment in the the market for loanable funds.market for loanable funds.

The market for loanable funds is the The market for loanable funds is the market in which those who save market in which those who save supplysupply funds and those who borrow funds and those who borrow demanddemand funds. funds.

Figure 1 The Market for Figure 1 The Market for Loanable FundsLoanable Funds

Loanable Funds(in billions of dollars)

0

InterestRate Supply

Demand

5%

$1,200

Supply and Demand for Supply and Demand for Loanable FundsLoanable Funds

Loanable funds refers to all income that Loanable funds refers to all income that people have chosen to save and lend out, people have chosen to save and lend out, rather than use for their own consumption.rather than use for their own consumption.

The supply of loanable funds comes from The supply of loanable funds comes from people who have extra income they want people who have extra income they want to save and lend out.to save and lend out.

The demand for loanable funds comes The demand for loanable funds comes from firms and households that wish to from firms and households that wish to borrow to make investments.borrow to make investments.


Interest rateInterest rate Is the price of the loan (credit)Is the price of the loan (credit) Is the amount that borrowers pay for Is the amount that borrowers pay for

loans and the amount that lenders loans and the amount that lenders earnearn on their savingon their saving

in the market for loanable funds, we use in the market for loanable funds, we use the real interest rate. Ignore inflation.the real interest rate. Ignore inflation.


Financial markets work much like Financial markets work much like other markets in the economy.other markets in the economy.

The equilibrium of the supply and The equilibrium of the supply and demand for loanable funds demand for loanable funds determines the real interest rate.determines the real interest rate.


Government Policies That Affect Government Policies That Affect Saving and InvestmentSaving and Investment Taxes on saving (interest earnings).Taxes on saving (interest earnings). Taxes on investment expenditures.Taxes on investment expenditures. Government budget deficits and Government budget deficits and

surpluses.surpluses.

Policy 1: Saving IncentivesPolicy 1: Saving Incentives Taxes on interest income substantially reduce Taxes on interest income substantially reduce

the future payoff from current saving and, as the future payoff from current saving and, as a result, reduce the incentive to save.a result, reduce the incentive to save.

A tax cut on interest earnings increases the A tax cut on interest earnings increases the incentive for households to save at any given incentive for households to save at any given interest rate. interest rate. The supply of loanable funds curve shifts right.The supply of loanable funds curve shifts right. The equilibrium interest rate decreases.The equilibrium interest rate decreases. Amount of investment increases.Amount of investment increases.

Figure 2 An Increase in the Supply Figure 2 An Increase in the Supply of Loanable Fundsof Loanable Funds


0

InterestRate

Supply, S1 S2

2. . . . whichreduces theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Demand

1. Tax incentives forsaving increase thesupply of loanablefunds . . .

5%

$1,200

4%

$1,600

Policy 1: Saving IncentivesPolicy 1: Saving Incentives

If a change in tax law encourages If a change in tax law encourages greater saving, the result will be greater saving, the result will be lower interest rates and greater lower interest rates and greater saving and investment.saving and investment.

Policy 2: Investment Policy 2: Investment IncentivesIncentives

An investment tax credit increases An investment tax credit increases the incentive to borrow.the incentive to borrow.

Increases the demand for loanable Increases the demand for loanable funds.funds.

Shifts the demand curve to the right.Shifts the demand curve to the right. Results in a higher interest rate and a Results in a higher interest rate and a

greater quantity saved and invested.greater quantity saved and invested.

Figure 3 Investment Incentives Figure 3 Investment Incentives Increase the Demand for Loanable Increase the Demand for Loanable

FundsFunds


0

InterestRate

1. An investmenttax creditincreases thedemand for loanable funds . . .

2. . . . whichraises theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Supply

Demand, D1

D2

5%

$1,200

6%

$1,400

Policy 2: Investment Policy 2: Investment IncentivesIncentives

If a change in tax laws encourages If a change in tax laws encourages greater investment, the result will be greater investment, the result will be higher interest rates and greater higher interest rates and greater saving and investment.saving and investment.

Policy 3: Government Policy 3: Government Budget Deficits and Budget Deficits and

SurplusesSurpluses When the government spends more than When the government spends more than

it receives in tax revenues, the short fall it receives in tax revenues, the short fall ((G - TG - T) is called the budget deficit (flow ) is called the budget deficit (flow concept).concept).

Government borrows to finance its deficit. Government borrows to finance its deficit. Issues and sells bonds in the bond market.Issues and sells bonds in the bond market.

The accumulation of past budget deficits The accumulation of past budget deficits is called the government debt (stock is called the government debt (stock concept). concept).


SurplusesSurpluses Government borrowing to finance its budget Government borrowing to finance its budget

deficit reduces the supply of loanable funds deficit reduces the supply of loanable funds available to finance investment by firms. available to finance investment by firms.

This fall in investment is referred to as This fall in investment is referred to as crowding out.crowding out. This has been especially big This has been especially big problem for Turkey.problem for Turkey. The deficit borrowing crowds out private The deficit borrowing crowds out private

borrowers who are trying to finance borrowers who are trying to finance investments.investments. Also keeps int. rate very high. Also keeps int. rate very high.


SurplusesSurpluses A budget deficit decreases the supply A budget deficit decreases the supply

of loanable funds. of loanable funds. Shifts the supply curve to the left. Shifts the supply curve to the left. Increases the equilibrium interest Increases the equilibrium interest

rate.rate. Reduces the equilibrium quantity of Reduces the equilibrium quantity of

loanable funds.loanable funds.

Figure 4: The Effect of a Figure 4: The Effect of a Government Budget DeficitGovernment Budget Deficit


0

InterestRate

3. . . . and reduces the equilibriumquantity of loanable funds.

S2

2. . . . whichraises theequilibriuminterest rate . . .

Supply, S1

Demand

$1,200

5%

$800

6% 1. A budget deficitdecreases thesupply of loanablefunds . . .


SurplusesSurpluses When government reduces national When government reduces national

saving by running a deficit, the saving by running a deficit, the interest rate rises and investment interest rate rises and investment falls.falls.

A budget surplus increases the A budget surplus increases the supply of loanable funds, reduces the supply of loanable funds, reduces the interest rate, and stimulates interest rate, and stimulates investment.investment.

Figure 5 The U.S. Government Figure 5 The U.S. Government DebtDebt

Percentof GDP

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990

RevolutionaryWar

2010

CivilWar World War I

World War II

0

20

40

60

80

100

120

Turkey's Foreign Debt/GNP Source: CBRT, Treasury

0,0

10,0

20,0

30,0

40,0

50,0

60,0

70,0

80,0

90,0

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

CHAPTER 4: SAVING, INVESTMENT AND THE FINANCIAL SYSTEM.

Documents

financial systemfunction

coupon bond

investment funds

ytl face value

treasury discount bond

pension funds

shortage of funds

surplus funds