Download Financial Sector: Saving, Investment and the Financial System

Financial Sector: Saving,
Investment and the Financial
System
AP Economics
Mr. Bordelon
Savings-Investment Spending Identity
• Savings-investment spending identity.
Savings and investment spending are always
equal for the economy as a whole.
▫ Why? This is an algebraic identity, so bare with
me.
Savings-Investment Spending Identity
• Assume there is an economy with no
government or foreign trade, meaning only
consumer and investment spending exist.
• Income would have to equal spending. People
earn income by selling, and that selling of goods
is done by spending.
• Total Income = Total Spending
Savings-Investment Spending Identity
• Total Income = Total Spending
• With income, consumers can either spend or save
money.
▫ Total Income = Consumer Spending (C) +
Savings (S)
• With spending, in this economy, spending is either
done by consumers or investors.
▫ Total Spending = C + Investment Spending (I)
• Total Income = Total Spending  C + S = C +
I
Savings-Investment Spending Identity
•C+S=C+IS=I
• In short, with a basic economy, we end up with
savings equal to investment. This is an
accounting principle.
• This is a simplified economy, however. What
happens when we add government spending and
net exports?
• Let’s add government spending first.
Savings-Investment Spending Identity
• Government spending implies that governments can
have savings.
▫ Budget surplus. Difference between tax revenue and
government spending when tax revenue exceeds
government spending.
• Government can also exceed its budget.
▫ Budget deficit. Difference between tax revenue and
government spending when government spending exceeds
tax revenue.
• One term to be aware of for our equation:
▫ Budget balance (BB). Difference between tax revenue
and government spending.
• National savings. Sum of private savings and BB.
Total amount of savings in the economy.
Savings-Investment Spending Identity
• Looking at government spending, government
spends money on g/s and pays transfers. To pay
for this, government collects tax revenue.
• If there is a balanced budget, then
tax revenue = G + gov’t transfer payments
• We can rewrite this equation to find the BB:
BB = tax revenue – G – transfers.
Savings-Investment Spending Identity
• BB = tax revenue – G – transfers
▫ If BB > 0, the government has a budget surplus
(saving)
▫ If BB < 0, the government has a budget deficit
(dissaving)
▫ If BB = 0, the government has a balanced
budget.
• S + BB. National savings—combination of
public and private sector.
▫ Awesome, so now what? Well, add it to the S = I
identity.
Savings-Investment Spending Identity
• S + BB = I
▫ BB > 0 (surplus): I increases.
▫ BB < 0 (deficit): I decreases.
▫ Even with surpluses and deficits, the S = I identity
holds true.
• Excellent. BUT THAT’S NOT ALL! Remember
we need to look at net exports.
Savings-Investment Spending Identity
• Two Sides:
▫ Americans save money in U.S. or elsewhere.
▫ Foreigners can save money in home country or
U.S.
▫ In other words, for any country, there is a series of
capital inflows (savings) and outflows (spending).
▫ Capital inflow (CI). Net inflow of funds into a
country. Mathematically:
CI = total inflow of foreign funds – total outflow of
domestic funds
Savings-Investment Spending Identity
• CI = total inflow of foreign funds – total outflow
of domestic funds
• CI can be positive or negative, which means it
can increase or decrease total funds available for
investment.
▫ CI > 0: more foreign funds coming in than U.S.
funds going out
▫ CI < 0: less foreign funds coming in than U.S.
funds going out.
Savings-Investment Spending Identity
• Adding this to our S = I identity:
S + BB + CI = I
▫ CI > 0: more foreign funds coming in than U.S.
funds going out—I increases.
▫ CI < 0: less foreign funds coming in than U.S.
funds going out, I decreases.
Savings-Investment Spending Identity
• Summary:
S=I
S + BB = I
S + BB + CI = I
• For the AP exam, if they ask a question on S-I
identity, then it typically follows these equations.
▫ Example. In Miltonia, no foreign trade is
conducted. Which of the following would be an
accurate statement of the savings-investment
spending identity?
 C. S + BB = I
Financial System Tasks—Key Terms
• Interest rate. Price, calculated as a percentage of
the amount borrowed, charged by lenders to
borrowers for the use of their savings for one year.
• Wealth. Value of accumulated savings.
• Financial asset. Paper claim that entitles the
buyer to future income from the seller.
• Physical asset. Claim on a tangible asset that
gives the owner the right to dispose of the object as
he sees fit.
• Liability. Requirement to pay money in the future.
• Keep these terms in mind as you focus on what
financial systems do.
Financial System Tasks
• Reduce transaction costs.
▫ Transaction costs. Expenses of negotiating and
executing a deal.
▫ Example. Billy wants to buy a loaf of bread, a pound of
apples, and a dozen eggs. He could drive to the bakery,
then the orchard, and then to the farm. However, it is more
convenient, and less costly, to buy it all at Winn-Dixie.
▫ Example. Xayavong, LTD wants to borrow money to
build a factory. Xayavong could go individually to Katie,
Ryan, etc. for a loan. Or Xayavong could just simply go to a
bank, which specializes in providing these funds. Banks,
and other financial services companies, are able to make it
easier, and less costly, for firms to engage in financial
transactions like borrowing to make investments.
Financial System Tasks
• Provide liquidity. Liquidity is about the ease you
can turn an asset into cash.
▫ iPad is an asset, but not all that liquid.
▫ Savings account is an asset, and very liquid.
▫ Example. If Xayavong, LTD needs money to build a
factory, that investment in a physical asset will not
provide a stream of cash revenue for a long time. Until
the factory begins to produce goods that generate
revenue, Xayavong may need liquidity (cash) to
purchase raw materials, hire some workers and pay
the electric bill. The financial system can provide
liquidity by issuing loans, bonds, or stocks.
Financial System Tasks
• Reduce risk.
▫ Financial risk. Uncertainty about future outcomes that
involve financial losses and gains.
▫ Example. Given an uncertain future in investing, building
a factory may have a risk that it will not be profitable.
Xayavong, LTD may want to build the factory, but using her
own money is risky because the factory might not be
profitable. Xayavong could raise the money by selling
shares of stock in the company. When a person buys a share
of stock in a company, it gives that person a small stake in
the ownership of the company. Xayavong can pay for the
factory, but does not need to risk her own money if the
factory should fail to generate profits.
▫ Diversification. Investing in several different assets so
that possible losses are minimized.
Financial Assets
• Loans. Lending agreement between an individual
lender and individual borrower. Unsecured.
• Bonds. Securitized debt. Seller of a bond promises
to pay fixed sum of interest each year and to repay
principal to owner of the bond on a particular date.
• Securities. Asset created by pooling individual
loans and shares in that pool.
• Stocks. Share in ownership of a company, entitling
stockholder to a share of the profits.
Financial Intermediaries
• Financial intermediary. Institution that transforms funds
gathered from many individuals into financial assets.
▫ Mutual funds. Creates a stock portfolio by buying and holding
shares in companies and then selling shares of the stock portfolio
to individual investors.
▫ Pension Funds and Life Insurance Companies. Pension
funds are non-profit institutions that collect the savings of its
members and invest those funds in a wide variety of assets,
providing retirement income. Life insurance companies sell
policies which guarantee a payment to the policyholder’s
beneficiaries when policyholder dies.
▫ Banks. Financial intermediary that provides liquid assets in the
form of deposits to lenders and uses their funds to finance the
illiquid investment spending needs of borrowers.
Question 1
Please complete the following for each of the four
financial assets presented in the textbook.
1. Define each financial asset.
2. Provide a specific example of each financial
asset and the price at which it is selling. For
example, the price of a loan is the rate of interest
being charged to the borrower.
3. How does each asset provide the necessary
functions of lowered transaction costs, reduced
risk, and liquidity?
Question 2
Given the following information about the closed
economy of Brittania, what is the level of investment
spending and private savings, and what is the budget
balance? What is the relationship among investment
spending, private savings, and the budget balance? Is
national savings equal to investment spending? There
are not government transfers.
• GDP = $1,000 million
• C = $850 million
• Tax Revenue = $50 million
• G = $100 million
Question 3
• Which of the following are examples of investment
spending, investing in financial assets, or investing
in physical assets?
▫ Rupert Moneybucks buys 100 shares of existing CocaCola stock.
▫ Rhonda Moviestar spends $10 million to buy a
mansion built in the 1970s.
▫ Ronald Basketballstar spends $10 million to build a
new mansion with a view of the Pacific Ocean.
▫ Rawlings builds a new plant to make catcher’s mitts.
▫ Russia buys $100 million in U.S. government bonds.