Module 22: Saving, Investment, and the Financial

MODULE 22: SAVING, INVESTMENT, AND THE FINANCIAL

SYSTEM

The purpose of this module is to introduce the financial system and the key roles that saving and investment play. This module also begins to prepare students to learn about the Federal Reserve and monetary policy in future modules.

Student learning objectives:

The relationship between savings and investment spending.

The purpose of the five principal types of financial assets: stocks, bonds, loans, real estate, and bank deposits.

How financial intermediaries help investors achieve diversification.

Key Economic Concepts For This Module:

The savings investment identity tells us that, in a simple economy without government or foreign trade, that private dollars saved must equal private dollars invested.

When the government is included, we discover that the government can also contribute to national savings if there is a budget surplus, and can detract from national savings if there is a budget deficit.

Money can also flow into the U.S. from foreign citizens and money can flow from the U.S. into foreign economies. This inflow or outflow affects domestic saving and investment.

If foreign citizens save more money in the U.S., than Americans save in other nations, there exists a positive capital inflow of money into the U.S. This increases domestic investment.

If Americans save more in other nations, than foreign citizens save in the U.S., there exists a negative capital inflow of money in the U.S. This decreases domestic investment.

The financial system facilitates transactions between savers and investors and provides three key roles in the process: reducing transaction costs, reducing risk, and increasing liquidity.

Common Student Difficulties:

It is intuitive for students to understand that they have two choices with their income: consume it or spend it. However, students can find it difficult to understand that the government and foreign sectors also have those options.

The use of a simple hypothetical example of government saving (or dissaving) and positive (or negative) capital inflow can illustrate how this affects domestic investment.

Eyes can glaze over when discussion turns to financial assets and financial intermediaries. It might be helpful to give the students a mini-research assignment to look up one of the assets or intermediaries and present to the group what it (or they) does. A guest speaker from a bank, insurance company, or investment firm could also energize the discussion.

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In-Class Presentation of Module and Sample Lecture

Suggested time: This module can be covered in one hour-long class session, with the focus being on the savings-investment identity. Students can be assigned out of class work to familiarize themselves with the types of financial assets and intermediaries.

1. Matching Up Savings and Investment Spending

1. The Savings– Investment Spending Identity II. The Financial System

1. Three Tasks of a Financial System

1. Reducing Transaction Costs
2. Reducing Risk
3. Providing Liquidity

1. Types of Financial Assets
2. Loans
3. Bonds

1. Loan-backed Securities
2. Stocks

1. Financial Intermediaries
2. Mutual Funds
3. Pension Funds and Life Insurance Companies

1. Banks

1. Matching Up Savings and Investment Spending

When a firm invests in physical capital (factories, shopping malls, large pieces of machinery, etc), the firm usually pays for these big projects by borrowing. Those funds have to come from somewhere.

This module will discuss the source of those funds and the entities that help to provide access to the funds.

1. The Savings– Investment Spending Identity

Note: stress from the beginning that savings equals investment. S=I

This is known as the savings–investment spending identity.

We start with the simplest of economies, but it still holds when we bring in the public and foreign sectors.

Simple economy: no government, no trade (zero imports and exports).

Remember the very simple circular flow diagram. All money spent by consumers and firms ends up in another person’s pocket as income (including profit).

Total income  Total spending = C + I

Now, what do people do with income? They either spend it on consumption (C) or save it (S).

Total income  C + S = Total Spending = C + I

C + S = C + I

Or

S = I

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What if the economy isn’t so simple?

Add the government (public sector) to the private sector.

The government spends on goods and services (G) and pays transfers to some. The government collects tax revenue to pay for these things.

If the government budget is balanced:

Tax revenue = government spending + transfer payments

Rearrange this equation and call it Budget Balance (BB)

Budget Balance = Tax Revenue – G – transfers

If BB >0, the government has a budget surplus and is actually saving money.

If BB<0, the government has a budget deficit and is borrowing money (dissaving).

We can now include public sector savings to the savings-investment identity.

S + BB: simply total national savings.

S + BB = I

If BB>0 on the left side (a surplus), I must increase on the right side.

If BB<0 on the left side (a deficit), I must decrease on the right side.

Final level of complexity.

Add the foreign sector.

An American can save her money in the U.S. or in another nation.

A foreign citizen can save his money in his home country, or in the U.S.

So the U.S. receives inflows of funds—foreign savings that finance investment spending in the US.

The U.S. also generates outflows of funds—domestic savings that finance investment spending in another country.

Let’s define:

Capital inflow into the U.S. =total inflow of foreign funds - total outflow of domestic funds to other countries.

Capital inflow (CI) can be positive or negative so it can increase or decrease the total funds available for investment in the U.S. economy.

S + BB + CI = I

If CI > 0 on the left side (more foreign funds coming into the U.S., than U.S. funds going out), I must increase on the right side.

If CI < 0 on the left side (fewer foreign funds coming into the U.S., than U.S. funds going out), I must decrease on the right side.

1. The Financial System

Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets.

A financial asset is a paper claim that entitles the buyer to future income from the seller.

There are four types of financial assets.

Before we get into those specific assets, we look at the role the financial system plays in exchanging the assets from the seller to the buyer.

1. Three Tasks of a Financial System

1. Reducing Transaction Costs

Suppose a consumer wanted to buy a loaf of bread, a pound of apples, and a dozen eggs. One way to do this is to drive to the bakery, then drive to the orchard, and then drive to the farm. It is surely more convenient, and less costly, to buy from a firm that specializes in providing these items: the supermarket.

Suppose a firm wanted to borrow some money to build a factory. One way to borrow would be to go to Mr. Jones for a loan, Ms. Sanchez for another loan, the Johnson family for another… Or the firm could find a firm that specializes in providing these funds: a bank.

The bank, and other financial services companies, is able to make it easier, and less costly, for firms to engage in financial transactions like borrowing to make investments.

1. Reducing Risk

The future is uncertain so investments, like building a factory, have a risk that they will not be profitable.

The owner of a firm may want to build the factory, but using his/her own money is risky because the factory might not be profitable. The owner 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. The primary owner of the business can pay for the factory, but does not need to risk his/her own money if the factory should fail to generate profits.

Diversification: investing in several assets with unrelated, or independent, risks—allows a businessowner to lower his/her total risk of loss.

The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and a stock market.

1. Providing Liquidity

Liquidity refers to the ease by which an asset can be converted to cash.

A vintage Rolls Royce is a valuable asset, but isn’t very liquid.

A savings account is very liquid.

If a firm 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, the firm may need liquidity (cash) to purchase raw materials, hire some workers and pay the electric bill. The financial system can provide liquidity in a variety of ways: by issuing loans, bonds, or stocks.

Note: It is suggested that the instructor not present the following sections in class.

However, the students should become familiar with these assets and intermediaries. This is probably best done with a homework assignment.

1. Types of Financial Assets

1. Loans

A loan is a lending agreement between an individual lender and an individual borrower.

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1. Bonds

The seller of a bond promises to pay a fixed sum of interest each year and to repay the principal—the value stated on the face of the bond—to the owner of the bond on a particular date.

1. Loan-backed Securities

Loan-backed securities are assets created by pooling individual loans and selling shares in that pool (a process called securitization).

1. Stocks

A stock is a share in the ownership of a company.

1. Financial Intermediaries

A financial intermediary is an institution that transforms funds gathered from many individuals into financial assets. The most important types of financial intermediaries are mutual funds, pension funds, lifeinsurance companies, and banks.

1. Mutual Funds

A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors.

1. Pension Funds and Life Insurance Companies

Pension funds are nonprofit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing their members with income when they retire.

Life insurance companies sell policies which guarantee a payment to the policyholder’s beneficiaries (typically, the family) when the policyholder dies.

1. Banks

A bank is a financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance the illiquid investment spending needs of borrowers.

In-Class Activities and Demonstrations

It is unlikely that the AP Macroeconomics exam will test students on the finer points of financial assets and financial intermediaries. However, students should know the basics and this could be accomplished by assigning a worksheet like the one provided on the following page as homework.

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Financial Assets:

Please complete the following worksheet for each of the four financial assets presented in your textbook.

1. Define each financial asset.

1. Provide a specific example of each financial asset and the price at which it is selling. Note: the price of a loan is the rate of interest being charged to the borrower.

1. How does each asset provide the necessary functions of: lowered transaction costs, reduced risk, and liquidity?

Financial Intermediaries:

Please complete the following worksheet for each of the four financial intermediaries presented in your textbook.

1. Locate a specific example of each financial intermediary in your city or state.

1. Describe the products that each of the firms in #1 offers.

1. How does each firm in #1 attempt to differentiate itself in a very competitive market for these products?

1. How does each firm provide the necessary functions of: lowered transaction costs, reduced risk, and liquidity?

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