Chapter 9 Outline The Supply of Savings The Demand to Borrow Equilibrium in the Market for Loanable Funds The Role of Intermediaries Banks Bonds and Stock Markets What Happens When Intermediation Fails ID: 568721
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Slide1
Saving, Investment, and the Financial System
Chapter 9 Slide2
OutlineThe Supply of SavingsThe Demand to BorrowEquilibrium in the Market for Loanable FundsThe Role of Intermediaries: Banks, Bonds, and Stock MarketsWhat Happens When Intermediation Fails?
The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking
2Slide3
IntroductionSavings are necessary for capital accumulation. The more capital an economy can invest, the greater is GDP per capita. Connecting savers and borrowers increases the gains from trade and smoothens economic growth
.
3Slide4
DefinitionSaving:Income that is not spent on consumption goods.
4
Investment
:
The purchase of new capital goods. Slide5
Supply of SavingsFour of the major factors that determine the supply of savings: Smoothing consumption. Impatience. Marketing and psychological factors.
Interest rates.
5Slide6
Smoothing Consumption If you consume what you earn every year, consumption is high during your working years. After retirement consumption drops precipitously. You can smooth your consumption by saving during the working years and dissaving during the retirement years.
Saving also builds a cushion for unemployment or unexpected health problems.
6Slide7
Smoothing Consumption
7Slide8
Impatience Most individuals prefer to consume now rather than later. The more impatient a person, the more likely that person’s savings rate will be low. Impatience is reflected in any economic situation where people must compare costs and benefits over time. Criminals, addicts, alcoholics, and smokers all tend to discount the future more heavily.
8Slide9
DefinitionTime preference:The desire to have goods and services sooner rather than later (all else being equal).
9Slide10
Marketing and Psychological Factors Individuals save more if saving is presented as the natural or default alternative. The retirement savings plan participation rate was 25% higher in businesses that used automatic enrollment rather than opt in. The default also mattered for how much was saved.
Simple psychological changes, combined with marketing, can change how much people save.
10Slide11
The Interest Rate
Savings
(billions of dollars)
Interest
rate
Supply
of savings
$200
$280
10%
5%
The higher the interest rate, the greater the quantity saved
11Slide12
Self-Check12
Which of the following is a major factor in determining the supply of savings?
GDP.
Patience.
Investment.
Answer: b
–
patience is one of the major factors, along with consumption smoothing, interest rates, and marketing and psychological factors .
Slide13
The Demand to Borrow One reason people borrow is to smooth consumption. Many young people borrow to invest in their education. Borrowing moves some sacrifices into future periods when students’ income is higher. By borrowing, saving, and dissaving, workers can smooth their consumption over their lifetime.
13Slide14
The Demand to Borrow The lifecycle theory of savings puts the demand to borrow and save together.
14Slide15
The Demand to Borrow Businesses borrow to finance large projects. Often the people with the best business ideas are not the people with the most savings.Example: Fred Smith and FedEx
Many ventures cannot “start small”
The ability to borrow greatly increases the ability to invest.
Higher investment increases the standard of living and the rate of economic growth.
15Slide16
The Demand to Borrow16
The lower the interest rate, the greater the quantity of funds demanded.Slide17
DefinitionMarket for loanable funds:Occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers). Trading in the market for loanable funds determines the equilibrium interest rate.
17Slide18
The Demand to Borrow Interest Rates – the “price” of moneyDetermines the cost of the loanAn investment will be profitable only if its rate of return is greater than the interest rate.
The higher the interest rate, the smaller the quantity demanded of savings will be:
There are fewer investments that “make the cut” of yielding a higher return than it costs to borrow the funds to finance the project
18Slide19
Equilibrium in Loanable FundsIn equilibrium, the quantity of funds supplied equals the quantity of funds demanded. The interest rate adjusts to equalize savings and borrowing. If the interest rate is higher than equilibrium, the quantity of savings supplied > the quantity of savings demanded, creating a surplus.
With a surplus of savings, suppliers will bid the interest rate down as they compete to lend.
19Slide20
Equilibrium in Loanable Funds
Savings/borrowing
(in billions of dollars)
Interest
rate
Supply
of savings
Demand to borrow
8%
$250
Equilibrium
interest
rate
Equilibrium quantity
of savings/borrowing
20Slide21
Equilibrium in Loanable Funds
Savings/borrowing
(in billions of dollars)
Interest
rate
Supply
of savings
$280
10%
Demand to borrow
$190
8%
$250
21
SurplusSlide22
Equilibrium in Loanable Funds
Savings/borrowing
(in billions of dollars)
Interest
rate
Supply
of savings
$200
10%
6%
Demand to borrow
$300
8%
$250
22
ShortageSlide23
Self-Check23
If there is a shortage of loanable funds, the interest rate will:
Increase.
Decrease.
Stay the same.
Answer: a
–
increase; if there is a shortage, borrowers will bid the rate up.
Slide24
Shifts in Supply and DemandChanges in economic conditions will shift the supply or demand curve. The shift will change the equilibrium interest rate and quantity of savings.Example:
If the stock market crashes, people save more to restore their wealth
24Slide25
People Become More Thrifty
25
Savings/borrowing
(in billions of dollars)
Interest
rate
Supply
of savings
5%
Demand
to borrow
$300
8%
$250
New supply of savings
25
Lower interest rate
Greater savings and borrowingSlide26
Shifts in Supply and DemandExample:Investors become more pessimistic during a recession and reduce their borrowingCauses demand curve for loanable funds to shift inward (a reduction in demand).
26Slide27
Investors Become Less Optimistic
27
Savings/borrowing
(in billions of dollars)
Interest
rate
Supply
of savings
$200
5%
Demand to borrow
8%
$250
New demand to borrow
27
Lower interest rate
Lower savings and borrowingSlide28
DefinitionFinancial intermediaries:Such as banks, bond markets, and stock markets reduce the costs of moving savings from savers to borrowers and investors.
28Slide29
The Role of Intermediaries Equilibrium in the market for loanable funds does not come about automatically.Savers move their capital to find the highest returns. Entrepreneurs must find the right investments and the right loans. Financial intermediaries (“middlemen”)
reduce the costs of moving savings from savers to borrowers and help mobilize savings toward productive uses.
29Slide30
Banks Banks receive savings from many individuals and pay them interest. They loan these funds to borrowers, charging them interest. Banks earn profit by charging more for their loans than they pay for the savings. They earn this money by providing services such as evaluating investments and spreading risk.
30Slide31
Banks By specializing in loan evaluation, banks are better able to decide which business ideas make sense. It would be wasteful if every saver spent time evaluating the same business. Banks coordinate lenders and minimize information costs. Banks spread default risk across many lenders.
Banks also play a role in the payments system.
31Slide32
Self-Check32
The main function of financial intermediaries is to:
Make capital investments.
Provide investment advice.
Mobilize savings towards productive uses.
Answer: c
–
financial intermediaries reduce the costs of moving savings to investors and mobilize the savings towards productive uses.
Slide33
The Bond Market Investors can more easily find information about large, well-known corporations. They are therefore more willing to bypass banks and lend to these companies directly. Governments use bonds extensively as wellA corporation acknowledges its debt to a member of the public by issuing a
bond
, or corporate IOU.
The bond contract lists how much is owed, the rate of interest, and when payment is due.
33Slide34
The Bond Market Bonds are a way to raise a large sum of money for long-lived assets, and pay it back over a long period of time. All bonds involve default risk, or the risk that the borrower will not pay back the loan.
A risky company has to pay higher interest to compensate lenders for a greater risk of default.
Interest rates differ depending on the borrower, repayment time, amount of the loan, type of collateral, and many other features.
34Slide35
The Bond Market Major issues are graded by rating companies:Standard and Poor’s
Moody’s
Grades range from
lowest risk (AAA)
bonds in current default (D)
The
higher
the
risk
the
greater
the
interest rate
required to get lenders to buy the bonds.
35Slide36
DefinitionCollateral:Something of value that by agreement becomes the property of the lender if the borrower defaults
.
36Slide37
Self-Check37
Something of value that becomes the property of the lender if the borrower defaults is called:
Collateral.
Interest.
A bond.
Answer: a
–
this is called collateral.
Slide38
DefinitionCrowding out:The decrease in private consumption and investment that occurs when government borrows more.
38Slide39
The Bond Market
Savings/borrowing
Interest
rate
Supply
of savings
$200
7%
Private +$100b govt. demand
9%
$250
Private
demand
a
b
Government borrows $100b
39
An increase in government borrowing crowds out private consumption and investment.
c
$150Slide40
The Bond Market
Savings/borrowing
Interest
rate
Supply
of savings
$200
7%
Private +$100b govt. demand
9%
$250
Private
demand
a
b
The higher interest rate draws forth more savings; private consumption falls.
40
An increase in government borrowing crowds out private consumption and investment.
$150
cSlide41
The Bond Market
Savings/borrowing
Interest
rate
Supply
of savings
$200
7%
Private +$100b govt. demand
9%
$250
Private
demand
a
b
c
$150
The higher interest rate also reduces the demand to borrow and invest.
41
An increase in government borrowing crowds out private consumption and investment. Slide42
U.S. Government BondsTreasury securities are desirable because they are easy to buy and sell and the U.S. government is unlikely to default. T-bonds
–
30-year bonds; pay interest every 6 months
.
T-notes
–
maturities ranging from 2 to 10 years; pay interest every 6 months
.
T-bills
–
maturities of a few days to 26 weeks; pay only at maturity
.
Zero-coupon bonds
–
pay only at maturity.
42Slide43
Bond Prices and Interest Rates The value of a bond at maturity is called the face value (FV). The rate of return, or implied interest rate, on a zero-coupon bond can be calculated as:
If you pay $909 for a 1-year bond with a face value of $1,000:
43Slide44
Bond Prices and Interest Rates Equally risky assets must have the same rate of return. If they didn’t, no one would buy the asset with the lower rate of return. The price would fall until the rate of return was competitive with other investments.This is called an
arbitrage
principle.
44Slide45
DefinitionArbitrage:The buying and selling of equally risky assets; arbitrage ensures that equally risky assets earn equal returns.
45Slide46
Bond Prices and Interest Rates Interest rates and bond prices move in opposite directions. When interest rates go up, bond prices fall; when interest rates go down, bond prices rise. This tells us that in addition to default risk, people who buy bonds also face interest rate risk.
46Slide47
Bond Prices and Interest Rates Assume a long term bond that pays $50/yearAssuming all other factors are constant:If the prevailing interest rate were 10%, what would you pay to own the bond?If interest rates fell to 5%, what would you pay to own the bond?
As interest rates fall, the market value of the bond rises, and vice-versa
What happens when interest rates are zero?
Bond market
Stock market
47Slide48
Self-Check48
The risk that a borrower will not pay the loan back is called:
Default risk.
Interest rate risk.
Crowding out.
Answer: a
–
this is called default risk.
Slide49
The Stock MarketBusinesses can fund their activities by issuing stock, or shares of ownership. Stocks are traded on organized markets called stock exchanges.Stock markets encourage investment and growth. Buying and selling existing shares of stock does
not
increase net investment in the economy.
When a firm sells
new
shares to the public (IPO), the proceeds often fund investment.
49Slide50
DefinitionStock:or a share is a certificate of ownership in a corporation. (equity)
50
Initial public offering (IPO)
:
The first time a corporation sells stock to the public in order to raise capital. Slide51
When Intermediation FailsThe bridge between savers and borrowers can be broken in many ways.
51Slide52
Insecure Property Rights Some governments do not offer secure property rights to savers. Savings may be confiscated, frozen, or subject to other restrictions. When Argentina froze bank accounts in 2001, many banks went under and Argentinians lost their savings. Russia has at times confiscated or restricted the value of shareholders’ holdings.
This negatively affects savings and investment.
52Slide53
Controls on Interest Rates Price controls on interest rates also cause the loanable funds market to malfunction. Usury laws impose a maximum ceiling on the interest rate that can be charged on a loan. Most U.S. states have usury laws, although often they have loopholes:
they don’t stop most credit card borrowing.
they are set at levels too high to influence most loan markets.
Credit card loan sharking at 29.99%
53Slide54
Controls on Interest Rates
Savings/borrowing
Interest
rate
Supply
$190
Controlled
Interest rate
Demand
8%
$300
$250
Shortage of savings
Less savings and investment
Slower economic growth
Market
Equilibrium
A Ceiling on Interest Rates Creates a Shortage of Savings
ShortageSlide55
Politicized LendingIn many countries, most large banks are owned by the government. Government-owned banks are useful for directing capital to political supporters. Useful to authoritarian regimesOne study found that the larger the fraction of government-owned banks a country had in 1970, the slower the growth in per capita GDP and productivity over the next several decades.
In the US, Countrywide Mortgage Company made many “sweetheart” loans to Congress
55Slide56
Bank Failures and Panics At the onset of America’s Great Depression between 1929 and 1933, almost half of all U.S. banks failed. Many people lost their life savings. Spending decreased, which meant that many businesses lost their customers and revenue. Businesses were unable to get loans or daily working capital and therefore failed.
It took many years before the American economy recovered.
56Slide57
The Financial Crisis of 2007-2008 Leading up to the crisis, Americans borrowed more than ever. The borrowing was centered in the housing and banking sectors.
In the 1990s and 2000s,
lenders became convinced that house prices were unlikely to fall.
They became willing to lend with much lower down payments
.
At the height of the housing boom in 2006, 17% of mortgages were made with 0% down.
57Slide58
DefinitionOwner equity:The value of the asset minus the debt, or E
=
V
−
D
.
58
Leverage ratio:
The ratio of debt to equity, or D/E. Slide59
The Financial Crisis of 2007-2008 Leverage A
house worth $400,000 with 20% down and a mortgage of $320,000:
Equity = $400,000 - $320,000 = $80,000
Leverage ratio = $320,000 / $80,000 = 4
A
house worth $400,000 with 10% down and a mortgage of $360,000:
Equity = $400,000 - $360,000 = $40,000
Leverage ratio = $360,000 / $40,000 = 9
59Slide60
DefinitionInsolvent:A firm that is insolvent has liabilities that exceed its assets.
Any recent examples?
60Slide61
The Financial Crisis of 2007-2008 Securitization The seller of a securitized asset gets cash.
The buyer gets a stream of future payments.
Mortgage loans were “securitized,” or bundled together and sold as financial assets.
Bad loans
were dumped on unsuspecting investors around the world.
61Slide62
The Financial Crisis of 2007-2008 Securitization Housing prices started to fall in 2007
.
Many owners owed more on their mortgage than their house was worth.
Delinquency and foreclosure rates more than doubled.
Many banks and financial intermediaries ended up with loans and assets of questionable value.
62Slide63
The Financial Crisis of 2007-2008 Shadow Banking Commercial banks fund themselves largely through deposits. These deposits are insured by the Federal Deposit Insurance Corporation (FDIC).
Investment banks are funded by investors and are not insured by the FDIC.
Shadow banking includes investment banks,
hedge funds, money market funds, and others.
63Slide64
The Financial Crisis of 2007-2008 At its peak in 2008 the shadow banking system lent $20 trillion, considerably more than did traditional banks.
64
The shadow banking system is less heavily regulated and monitored than traditional banks.
For years, regulators and policymakers were unaware of its importance.
Lehman Brothers declared bankruptcy in 2008.
OLI SCARFF/GETTY IMAGESSlide65
The Financial Crisis of 2007-2008 The CrisisAs house prices fell, highly leveraged home owners defaulted on their mortgages.
Highly leveraged banks were pushed towards insolvency.
It wasn’t always clear who owned what or who faced the worst losses.
Investors became unwilling to extend short-term funding to shadow banks.
Credit markets froze up - WAFD
("
We're all freaking doomed
.")
65Slide66
The Financial Crisis of 2007-2008
66
A
fire sale
is the vicious circle in which the forced sale of a financial asset drives down the price of related assets, forcing more sales, further driving down the price.
Slide67
The Financial Crisis of 2007-2008
67
The government has taken steps to avoid this happening again
.
After the Lehman Brothers failure, the Federal Reserve took over AIG when it was failing and guaranteed its debts.
New financial regulations are bringing the shadow banking system “out of the shadows”.
Banks of all kinds are required to hold more equity, reducing the amount of their leverage.
Slide68
Self-Check68
Banks that are funded by investors and are not insured by the FDIC are called:
Traditional banks.
Commercial banks.
Shadow banks.
Answer: c
–
shadow banks.
Slide69
TakeawaySaving and borrowing allow individuals, firms, and governments to smooth their consumption over time. Financial intermediaries bridge the gap between savers and borrowers. Financial intermediaries also collect savings, evaluate investments, diversify risk, and help finance new and innovative ideas.
69Slide70
TakeawayInsecure property rights, inflation, politicized lending, and bank failures and panics can all contribute to the breakdown of financial intermediation. The 2007–2008 crisis was brought about by high leverage and falling asset prices that created a panic and sharply reduced the amount of
lending in the economy.
70