Summary
Savings and Investment Spending
- 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.
- 3. The government is a source of savings when it runs a positive budget balance, also known as a budget surplus; it is a source of dissavings when it runs a negative budget balance, also known as a budget deficit.
- 4. In a closed economy, savings is equal to national savings, the sum of private savings plus the budget balance. In an open economy, savings is equal to national savings plus net capital inflow of foreign savings. When a negative net capital inflow occurs, some portion of national savings is funding investment spending in other countries.
The Market for Loanable Funds
- 5. 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.
- 6. Increasing or persistent government budget deficits can lead to crowding out: higher interest rates and reduced investment spending. This tells us that the demand curve for loanable funds is downward sloping. Changes in perceived business opportunities and in government borrowing shift the demand curve for loanable funds; changes in private savings and capital inflows shift the supply curve.
- 7. 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.
The Time Value of Money
- 8. The present value of a sum of money measures its value today.
- 9. The net present value of a project is the present value of current and future benefits minus the present value of current and future costs.
The Financial System
- 10. Households invest their current savings or 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.
- 11. A financial asset is also a liability from the point of view of its seller. 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).
- 12. Although many small and moderate-sized 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.
- 13. 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.
- 14. 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.
- 15. 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.
- 16. 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.