10.4 SUMMARY

1. Investment in physical capital is necessary for long-run economic growth. So in order for an economy to grow, it must channel savings into investment spending.

2. According to the savings-investment spending identity, savings and investment spending are always equal for the economy as a whole. The budget balance is equal to public savings, which is sometimes called government savings. When the government runs a budget surplus, public savings is positive and the government is a source of savings. On the other hand, when the government runs a budget deficit, then public savings is negative and the government is a source of dissavings. In a closed economy, national savings, the sum of private savings plus public savings, must be equal to investment spending. In an open economy, national savings can split between two kinds of investment: (domestic) investment spending and net foreign investment. Alternatively, domestic investment can be financed via national savings and/or negative NFI, which represents a net inflow of financial capital from abroad (i.e., in an open economy, the total savings available for investment in any given country, from both domestic and foreign sources, equals investment).

3. The hypothetical loanable funds market shows how loans from savers are allocated among borrowers with investment spending projects. By showing how gains from trade between lenders and borrowers are maximized, the loanable funds market shows why a well-functioning financial system leads to greater long-run economic growth. Increasing or persistent government budget deficits can lead to crowding out: higher interest rates and reduced investment spending. Changes in perceived business opportunities and government policies that affect investment shift the demand curve for loanable funds; changes in private savings and government budget balance shift the supply curve.

4. In order to evaluate a project in which the return, Y, is realized in the future, you must transform Y into its present value using the interest rate, i. The present value of $1 received one year from now is $1/(1 + i), the amount of money you must lend out today to have $1 one year from now. The present value of a given project rises as the interest rate falls and falls as the interest rate rises. This tells us that the demand curve for loanable funds is downward-sloping.

5. Because neither borrowers nor lenders can know the future inflation rate, loans specify a nominal interest rate rather than a real interest rate. For a given expected future inflation rate, shifts of the demand and supply curves of loanable funds result in changes in the underlying real interest rate, leading to changes in the nominal interest rate. According to the Fisher effect, an increase in expected future inflation raises the nominal interest rate one-to-one so that the expected real interest rate remains unchanged.

6. Households invest their current savings and their wealth—their accumulated savings—by purchasing assets. Assets come in the form of either a financial asset, a paper claim that entitles the buyer to future income from the seller, or a physical asset, a tangible object that can generate future income. A financial asset is also a liability from the point of view of its initial seller (or issuer). There are four main types of financial assets: loans, bonds, stocks, and bank deposits. Each of them serves a different purpose in addressing the three fundamental tasks of a financial system: reducing transaction costs—the cost of making a deal; reducing financial risk—uncertainty about future outcomes that involves financial gains and losses; and providing liquid assets—assets that can be quickly converted into cash without much loss of value (in contrast to illiquid assets, which are not easily converted).

7. Although many small and moderate-size borrowers use bank loans to fund investment spending, larger companies typically issue bonds. Bonds with a higher risk of default must typically pay a higher interest rate. Business owners reduce their risk by selling stock. Although stocks usually generate a higher return than bonds, investors typically wish to reduce their risk by engaging in diversification, owning a wide range of assets whose returns are based on unrelated, or independent, events. Most people are risk-averse, more sensitive to a loss than to an equal-sized gain. Loan-backed securities, a recent innovation, are assets created by pooling individual loans and selling shares of that pool to investors. Because they are more diversified and more liquid than individual loans, bonds are preferred by investors. It can be difficult, however, to assess a bond’s quality.

8. Financial intermediaries—institutions such as mutual funds, pension funds, life insurance companies, and banks—are critical components of the financial system. Mutual funds and pension funds allow small investors to diversify, and life insurance companies reduce risk.

9. A bank allows individuals to hold liquid bank deposits that are then used to finance illiquid loans. Banks can perform this mismatch because on average only a small fraction of depositors withdraw their funds at any one time. A well-functioning banking sector is a key ingredient of long-run economic growth.

10. Asset market fluctuations can be a source of short-run macroeconomic instability. Asset prices are determined by supply and demand as well as by the desirability of competing assets, like bonds: when the interest rate rises, prices of stocks and physical assets such as real estate generally fall, and vice versa. Expectations drive the supply of and demand for assets: expectations of higher future prices push today’s asset prices higher, and expectations of lower future prices drive them lower. One view of how expectations are formed is the efficient markets hypothesis, which holds that the prices of assets embody all publicly available information. It implies that fluctuations are inherently unpredictable—they follow a random walk.

11. Many market participants and economists believe that, based on actual evidence, financial markets are not as rational as the efficient markets hypothesis claims. Such evidence includes the fact that stock price fluctuations are too great to be driven by fundamentals alone. Policy-makers assume neither that markets always behave rationally nor that they can outsmart them.