Econ 2, Foldvary

Mankiw, Chapter 13

Saving and investment

Interest and time preference.

What is the economic meaning of interest?

Why do we get paid just for storing our money in a bank or money market account?

Time preference: the general preference of people for goods in the present relative to goods in the future.

Why? The human lifespan is finite. The future is uncertain.

So present-day goods have more market value than future goods.

Future goods have a discount. The farther into the future, the greater the discount.

The rate at which goods are discounted into the future constitutes the rate of interest.

The interest rate is a discount rate for time.

Interest is not about money. It is about time and uncertainty.

Money is just the form that interest takes.

In the economic system today, interest occupies a central place in the financial system.

The financial system consists of institutions that facilitate exchanges between lenders and borrowers, between savers and investors, and between risk seekers and risk avoiders.

The financial system facilitates exchanges that involve time, risk, and taxation.

Economic income is consumption plus a change in net worth.

Income comes as returns to factors: land, labor, capital goods.

Savings is income not used for consumption.

Investment is income used to produce or purchase capital goods and human capital.

The economic problem for savings and investment:

The people who want to save are often different from the people who want to invest.

So how do savings get to investors, and how do savings and investment get equalized?

Financial institutions such as banks, credit unions, mutual funds, and brokerage firms are intermediaries between savers and investors.

They are match-makers, go-betweens that arrange the transactions.

Banks loan to investors the savings of account holders.

Financial Markets

The bond market.

A bond is an IOU issued by a firm or a government.

It is a certificate of indebtedness. Nowadays electronic.

The amount borrowed is the principal.

Bonds are usually issued for a limited time interval, called the “term”.

The bond specifies the date of maturity, when the principal is paid back.

The bond also specifies an accounting rate of interest based on the face value at the time of purchase.

In Great Britain, there are perpetual bonds, called consols or perpetuities, which never mature.

The bond specifies how often interest is paid.

The market price of a bond is usually different from the face and maturity value.

If we ignore taxes, the market price (p) of a bond equals the annual return (r) divided by the real interest rate (i): p = r/i

With a tax rate t on the price p: p=r/(i+t)

The price of a bond with taxes compared to without taxes is:

[r/(i+t)] / [r/i] = i/(i+t).

So for bonds of the same price, the return on a taxed bond must be multiplied by (i+t)/i, e.g.:

p = [r(i+t)/i]/[i+t]

For example, if the interest rate is 4% and the tax rate is 1% of the price, then the taxed bond must pay r*.05/.04 = 1.25r to make the market price equal to that of a non-taxed bond.

If a municipal bond pays 4%, the taxed bond must pay 5%.

After paying 1% of the 5% as a tax, the returns are equalized.

For example, suppose the tax-free bond pays $100 per year at 4%.

The price of the bond is 100/.04 = $2500.

The taxed bond pays $125, and a 1% tax on $2500 is $25, so the after-tax return is $100.

The money or accounting interest paid by the borrower, bond issuer, consists of several elements:

1) pure interest. This is the real interest rate, excluding risk and taxation.

2) inflation premium. This makes up for the change or expected change in the price level.

            The US government issues inflation-protected bonds.

            The principal rises with inflation, although that increase is taxed.

            So this bond has no inflation premium.

3) risk premium. Risk is the possibility of a loss of the accounting interest or the principal.

            It is also called credit risk or default risk.

            A borrower can declare bankruptcy and have some debts cancelled.

            Credit card accounting interest is high because of the default risk.

            Corporate bonds that are very risky are called “junk bonds”.

            There are companies that rate the risk of bonds, such as Standard and Poor’s.

            Some state and local government bonds are risky;

            California has recently gotten a low credit rating.

            U.S. treasury bonds have no risk premiums.

4) fluctuation risk. The real interest, inflation, and thus the price of a bond can fluctuate.

            The fluctuation premium is higher for long-term than short-term bonds.

            There is also fluctuations risk from changes in the supply or demand for bonds.

5) The tax premium for having to pay taxes on the nominal return.

            Municipal (city) bonds are not subject to federal income taxes.

            California municipal bonds are also tax-free to California taxpayers.

            But municipal bonds may be taxed under the Alternative Minimum Tax.

            Federal treasury bonds are not subject to state income tax, but they are taxed by the federal income tax.

The stock market

A share of stock is a share of the ownership of a company and its profits.

The sales of stocks to raise funds is called equity finance.

The sale of bonds is called debt finance.

A corporation has a choice of paying dividends to the shareholders, or retaining the profits.

The profits of a corporation are taxed by the corporate income tax.

Dividends are taxed again by the personal income tax.

So if a company pays dividends, the profits are taxed twice.

Retained earnings are only taxed once.

This skews corporate policy to debt finance and retained earnings.

This distorts the financial markets; excessive borrowing creates a greater default risk, and a temptation by executives to misuse the profits that rightfully belong the shareholders.

A shareholder can compare the gains from his shares with a stock index based on the average value of some group of stocks. The main indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ index.

Stock tables in newspapers can include:

The name of the company and possibly its symbol.

The closing price, the price when trading for that day stops.

The day’s high and low price.

The volume of shares.

The dividend rate paid by the stock.

The price/earnings (per share) ratio.

Financial intermediaries are firms that go between and facilitate exchanges between lenders and borrowers. If you have an account at a bank, you are a lender.

The money deposited in a bank does not just sit there.

The bank lends it to borrowers.

Banks offers various ways of making loans.

A check is a loan. The check writer is getting goods, and pays with an IOU.

The check writer in effect borrows from the store, with his bank balance as collateral, and the store collects by depositing the check receipt and transferring the funds from the check writer.

If the check bounces, the check writer as borrower defaults on the loan.

A mutual fund is a corporation that owns a portfolio of stocks, bonds, and other assets.

The shareholders of the mutual fund are thus able to diversify their portfolio.

The fund can either offer stock-picking expertise or else match an index.

Mutual funds charge a management fee, but indexed-fund fees are low.

Saving and investment in national income accounting

Consumer borrowing just shifts consumption to others.

Total savings is income minus consumption. Consumer borrowing is netted out.

To simplify, assume a closed economy, with no foreign trade or money movements.

Y = C + G + I

Economic investment: an increase in the stock of capital goods and human capital.

I = Y - C - G

but savings also = Y - C - G.

So I = S, but as an equilibrium, because savers and different folks from investors.

If we add taxes T, then

S = (Y-T-C) + (T-G) or private savings plus government savings.

This year, G is a lot greater than T both for the federal government and California.

Both have budget deficits, and there is dissavings, or negative savings, i.e. borrowings.

The market for loanable funds.

Loanable funds include all funds offered to borrowers on the market.

The market for loanable funds consists of offers to loan funds and bids to borrow funds.

There is a supply and demand for loanable funds, just like with other things.

The supply of loanable funds comes from savings.

The demand comes from those who seek to borrow. This demand cure slopes down as usual.

The real rate of interest equilibrates the supply and demand for loanable funds, hence savings and investment. We keep it real by using the real interest rate.

The difference between a naive and a sophisticated lender or borrower is the recognition and use of the real interest rate.

Investment is important for the economy, since future productivity depends on investment.

Since investment spending comes from savings, if there is more savings, there is more investment.

But U.S. tax policy is designed to stimulate consumption and reduce savings.

Interest and dividend income is taxed.

The marginal tax rate influences the decision of whether to save.

The highest federal and state tax rates add up to about a 50% rate on income from savings.

Cutting returns in half substantially reduces the incentive to save and invest.

This is only partly offset with tax shelters such as IRAs.

Social Security taxes also substantially reduce savings, since it takes away 15% of a person’s income, leaving less to save, and it provides some pension income, reducing the incentive to save for retirement.

If taxation of interest were eliminated, and social security taxes also eliminated, the supply of savings would increase, reducing the rate of interest, increasing borrowing and investment.

The government provides some incentives for firms to invest with an investment tax credit.

This increases the demand for borrowing for investment, raising interest rates.

But selective tax credits create economic distortions.

Funds are shifted to investment having credits and away from other spending such as on labor.

It biases company spending away from labor and towards capital goods.

A government budget deficit also causes distortions.

Government bonds compete with corporate bonds, and reduces the supply of loanable funds for private investment, raising interest rates.

This is called “crowding out” private investment, and it reduces future economic growth.

A major cause of government budget deficits is military spending for war.

This is the case for this year’s budget deficit.

The structure of capital goods, and the interest rate.

Capital goods have a structure based on the rate at which the investment grows in value.

If interest rates fall, there are more investments in higher-order slow-growing goods.

Excessive money creation acts like more savings, but is not, so it causes distortions.

When interest rates rise again, the investments become unprofitable.

The stopping of investment leads to a recession and depression.

Financial markets have the important role of linking the present and the future.

Interventions such as taxation, restrictive regulations, and money creation distort these linkages and lead to macroeconomic instability, waste, and less wealth.