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CHAPTER 11 (22):
SAVINGS, INVESTMENT, AND THE
FINANCIAL SYSTEM
COREECONOMICS, 3RD EDITION BY ERIC CHIANG
Slides by Debbie Evercloud
© 2013 Worth Publishers
CoreEconomics ▪ Chiang/Stone
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CHAPTER OUTLINE
•
•
•
•
What Is Money?
The Market for Loanable Funds
The Financial System
Financial Tools for a Better Future
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LEARNING OBJECTIVES
• At the end of this chapter, the student will
be able to:
– Describe the functions of money
– Define M1 and M2
– Use the simple loanable funds model to show
how savers and borrowers are brought together
– Explain how the financial system makes it
easier for savers and borrowers
– Illustrate the relationship between bond prices
and interest rates
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LEARNING OBJECTIVES
• At the end of this chapter, the student will
be able to:
– Describe the tradeoff between risk and return
and how that influences the return on
investment for bonds and stocks
– Explain the simple financial concept of how
the compounding effect makes debt and
savings much larger over time.
– Understand how retirement savings programs
function and the benefits they provide
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EXAMPLE:
FINANCIAL CRISIS IN GREECE
• Recent events in Greece, as well as in
some other countries, show that disruptions
to the financial system can have farreaching effects on the macroeconomy.
– In this chapter, we will explore the functions of
money and financial institutions.
– This will lay the foundation for learning about
monetary policy in later chapters.
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BY THE NUMBERS:
THE SIZE OF FINANCIAL INSTITUTIONS
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WHAT IS MONEY?
• Money is anything that is accepted in
exchange for other goods and services or
for the payment of debt.
• For a commodity to be used as money:
– Its value must be easy to determine
– It must be divisible, so that people can make
change
– It must be durable
– It must be widely accepted in exchange
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WHAT IS MONEY?
• Our current financial system uses fiat
money, which means it has no intrinsic
value, but is recognized as legal tender.
• In a barter system, goods and services
are traded directly.
– This arrangement requires a double
coincidence of wants.
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FUNCTIONS OF MONEY
• Money must function as
– A medium of exchange
• This saves time in the process of conducting
transactions
– A unit of account
• Currency prices allow us to compare values of
two different commodities
– A store of value
• This allows for the process of saving
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FUNCTIONS OF MONEY
• Money is often used as a store of wealth
because it has such a high level of
liquidity.
– The liquidity of an asset is determined by how
fast, easily, and reliably it can be converted
into cash.
– Money is the most liquid asset because it
requires no conversion.
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DEFINITIONS OF THE MONEY
SUPPLY
• M1 = currency + demand deposits +
other checkable deposits
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DEFINITIONS OF THE MONEY
SUPPLY
• M2 = M1 + savings deposits + money
market deposit accounts + smalldenomination time deposits + shares
in retail money market mutual funds
net of retirement accounts
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M1
• Currency represents roughly half of the M1
money stock. Checking accounts
represent the other half.
• Currently, M1 is equal to roughly $2.5
trillion.
– It is the most liquid part of the money supply.
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M2
• A broader definition of money, M2,
includes the “near moneys”; funds that
cannot be drawn on instantaneously but
are nonetheless accessible.
• This includes deposits in savings
accounts, money market deposit accounts,
and money market mutual fund accounts.
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CHECKPOINT: WHAT IS
MONEY?
• Money is anything accepted in exchange
for other goods and services and for the
payment of debts.
• The functions of money include: a medium
of exchange, a unit of account, and a store
of value.
• Liquidity refers to how fast, easily, and
reliably an asset can be converted to cash.
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CHECKPOINT: WHAT IS
MONEY?
• M1 is currency plus demand deposits plus
other checkable deposits.
• M2 is equal to M1 plus savings deposits
plus other savings-like deposits.
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LOANABLE FUNDS
• Savers supply loanable funds to banks
and other financial intermediaries.
– The reward for not spending today is the
interest received on savings, enabling people
to spend more in the future.
– The supply of funds is directly related to interest
rates.
– At higher rates of interest, savers are rewarded
more and are willing to supply more funds.
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LOANABLE FUNDS
• The demand for loanable funds comes from
people who want to purchase goods and
services, such as taking out a home
mortgage, or starting a business.
• Firms are borrowers, too.
– Firms may want to invest in new plants, facilities,
or research.
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LOANABLE FUNDS
• The demand for loanable funds slopes
downward.
– This reflects the fact that when the real
interest rate is high, only a few projects will
have a rate of return high enough to justify
the cost of borrowing.
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Real Interest Rates, %
LOANABLE FUNDS
S
Equilibrium occurs when
the quantity of loanable
funds demanded equals the
quantity supplied.
3
D
300
Loanable Funds (billions of dollars)
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LOANABLE FUNDS
• The supply of loanable funds will shift in
response to changes in:
– The economic outlook
– Incentives to save
– Income or asset prices
– Government deficits
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LOANABLE FUNDS
• The demand for loanable funds will also
shift in response to changes in:
– Investment tax incentives
– Technological changes
– Regulations
– Product demand
– Business expectations
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CHECKPOINT: THE MARKET
FOR LOANABLE FUNDS
• Households supply loanable funds to the
market because they are rewarded with
interest income for saving.
• Firms demand funds to invest in profitable
opportunities.
• Any policy that provides additional
incentives for households to save will
increase the supply of loanable funds.
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CHECKPOINT: THE MARKET
FOR LOANABLE FUNDS
• Anything that increases the potential
profitability (rate of return) of business
investments will increase the demand for
loanable funds.
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FINANCIAL SYSTEM
• Our financial system is a complex network
of institutions that allocates scarce
resources from savers to borrowers.
• Financial intermediaries include:
– Commercial banks
– Savings-and-loan associations
– Credit unions
– Insurance companies, securities firms, and
pension funds
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FINANCIAL SYSTEM
• Financial institutions serve to:
– Reduce information costs
– Reduce transactions costs
– Spread risk by diversifying assets
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RETURN ON INVESTMENT
• The primary difference between types of
financial assets available is the return on
investment (ROI) one can achieve.
– A return on investment can be determined by
the interest rate earned on savings accounts
or CDs, or the capital gains, dividends, and
other interest earned from an investment.
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BOND PRICES AND INTEREST
RATES
• A bond is a contract between a seller and a
buyer that determines the following items:
– Coupon rate of the bond
– Maturity date of the bond
– Face value of the bond
• Once a bond is issued, it is subject to the
forces of the marketplace.
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BOND PRICES
• The yield on a bond is equal to its annual
interest payment divided by its price.
• Therefore , it is also true that:
Bond price = Interest payment / yield
• If a bond pays $50 per year interest, and
the yield should be 8 percent, then the
bond price will be $625:
$625 = $50 / .08
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BOND PRICES AND INTEREST
RATES
• It is important to remember that bond
prices and interest rates are inversely
related.
• Higher interest rates will cause bond
prices to fall.
Interest
Rates
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Bond
Prices
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SHARES OF STOCK
• An alternative to placing savings into
banks or bonds is to purchase shares of
stock in a company.
• Shares of stock represent ownership.
• Given their higher risk, stocks tend to
reward investors with a higher average
return on investment over the long run.
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RISK AND RETURN
• The general rule of the tradeoff between
risk and return states that riskier assets
typically offer a greater return.
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CHECKPOINT:
THE FINANCIAL SYSTEM
• Financial institutions reduce transaction
costs, information costs, and risk, making
financial markets more efficient.
• Financial assets include savings and
checking accounts, certificates of deposit
(CDs), bonds, stocks, and mutual funds.
• Bond prices and interest rates are
inversely related.
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CREDIT CARD DEBT
• The most common short-term loan comes
in the form of credit card debt.
• Credit card companies may provide
teaser rates, which are offers of low or
zero interest for a limited time on
purchases or balance transfers.
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CREDIT CARD DEBT
• Because of the high costs of holding credit
card debt, it is generally advisable to:
– Keep credit card balances to a minimum
– Find lower cost borrowing opportunities
– Avoid applying for too many credit cards
– Never miss a minimum payment
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COMPOUNDING EFFECT
• Even for low interest rates, the effect on
long-run payments can be substantial due
to the compounding effect.
– Compounding occurs when interest is
calculated and added on a periodic basis to
money borrowed or saved in addition to the
interest already charged or earned.
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EMPLOYER-BASED
SAVINGS PROGRAMS
• Most retirement savings programs allow
employees to contribute a certain
percentage of their earnings to a
retirement account.
– Many companies will then offer a full or partial
match of the contribution.
– The vesting period is the minimum
employment years required before the
employer-paid portion remains in the account.
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ISSUE: THE STOCK MARKET CRASH
AND RETIREMENT SAVINGS
• In 2012, many Americans were pleased to
find that their retirement accounts had
recovered from losses experienced during
the 2008 financial crisis.
– This was because they had continued to
contribute to these accounts, and funds were
invested at the new lower asset prices,
allowing them to capture benefits of the
stock market recovery.
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RETIREMENT SAVINGS
• In addition to employer-sponsored
retirement contribution funds, there are
other programs that allow individuals to
save for their future.
– Social Security
– Employer-based pension programs
– Individual retirement arrangement programs
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PENSIONS
• Pensions are an alternative to 401K-type
accounts.
– Pensions are monthly payments made by
your employer from the day you retire until
you die, based on the number of years you
worked at the company.
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CHECKPOINT: FINANCIAL
TOOLS FOR A BETTER FUTURE
• Credit cards typically are an expensive
way to finance borrowing.
• Debt and savings rise rapidly over the long
term because of the compounding effect.
• A tradeoff exists between risk and return:
The greater the risk, the higher the
average return on investment.
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CHAPTER SUMMARY
• Money is anything that is accepted in
exchange for goods and services or the
payments of debts.
• The two primary money supply measures
are M1 and M2.
• The market for loanable funds describes
the financial market for saving and
investment.
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CHAPTER SUMMARY
• Financial intermediaries accept funds from
savers and efficiently channel these to
borrowers, reducing transaction and
information costs, as well as lowering risk.
• The compounding effect is a powerful tool
that causes debt and savings to increase
dramatically over time.
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DISCUSSION QUESTIONS
• Fiat money has no intrinsic value. What,
then, determines its value?
• What types of events in your life have
influenced your willingness to save
money?
• Why is it essential for a smoothly
functioning economy to have both savers
and borrowers?
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