Lecture 4
10.3.2015
Saving, Investment,
and the Financial
System
Copyright © 2004 South-Western
Outline
• How does the economy coordinates saving and
investment?
• The Financial System – financial markets and
financial intermediaries
• What ensures that the supply of funds from
those who want to save balances the demand
for funds from those who want to invest?
• A model of the supply and demand for funds &
government policies (through interest rate)
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The Financial System
• The financial system consists of the group of
institutions in the economy that help to match
one person’s saving with another person’s
investment.
• It moves the economy’s scarce resources from
savers to borrowers.
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FINANCIAL INSTITUTIONS IN THE
U.S. ECONOMY
• The financial system is made up of financial
institutions that coordinate the actions of savers
and borrowers.
• Financial institutions can be grouped into two
different categories: financial markets and
financial intermediaries.
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FINANCIAL INSTITUTIONS IN THE
U.S. ECONOMY
• Financial Markets
• Institutions through which savers can directly
provide funds to borrowers.
• Stock Market
• Bond Market
• Financial Intermediaries
• Financial institutions through which savers can
indirectly provide funds to borrowers.
• Banks
• Mutual Funds
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Financial Markets
• The Bond Market
• A bond is a certificate of indebtedness that
specifies obligations of the borrower to
the holder of the bond.
• Characteristics of a Bond
• Term: The length of time until the bond matures.
• Credit Risk: The probability that the borrower will fail to
pay some of the interest or principal.
• Tax Treatment: The way in which the tax laws treat the
interest on the bond.
• Municipal bonds are federal tax exempt.
IOU
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Financial Markets
• The Stock Market
• Stock represents a claim to partial ownership in a
firm and is therefore, a claim to the profits that the
firm makes.
• The sale of stock to raise money is called equity
financing.
• Compared to bonds, stocks offer both higher risk and
potentially higher returns.
• The most important stock exchanges
• US - the New York SE, the American SE, and NASDAQ
• London SE, Tokyo SE
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Financial Markets
• The Stock Market
• Most newspaper stock tables provide the following
information:
• Price (of a share)
• Volume (number of shares sold)
• Dividend (profits paid to stockholders)
• Price-earnings ratio
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Financial Intermediaries
• Financial intermediaries are financial
institutions through which savers can indirectly
provide funds to borrowers.
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Financial Intermediaries
• Banks
• take deposits from people who want to save and use
the deposits to make loans to people who want to
borrow.
• pay depositors interest on their deposits and charge
borrowers slightly higher interest on their loans.
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Financial Intermediaries
• Banks
• Banks help create a medium of exchange by
allowing people to write checks against their
deposits.
• A medium of exchanges is an item that people can easily
use to engage in transactions.
• This facilitates the purchases of goods and services.
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Financial Intermediaries
• Mutual Funds
• A mutual fund is an institution that sells shares to
the public and uses the proceeds to buy a portfolio,
of various types of stocks, bonds, or both.
• They allow people with small amounts of money to
easily diversify.
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Financial Intermediaries
• Other Financial Institutions
• Credit unions
• Pension funds
• Insurance companies
• Loan sharks
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SAVING AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
• Recall that GDP is both total income in an
economy and total expenditure on the
economy’s output of goods and services:
Y = C + I + G + NX
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Some Important Identities
• Assume a closed economy – one that does not
engage in international trade:
Y = C + I + G
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Some Important Identities
• Now, subtract C and G from both sides of the
equation:
Y – C – G =I
• The left side of the equation is the total income in the
economy after paying for consumption and
government purchases and is called national saving, or
just saving (S).
• Substituting S for Y - C - G, the equation can be
written as:
S = I
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Some Important Identities
• National saving, or saving, is equal to:
S = I
S = Y – C – G
S = (Y – T – C) + (T – G)
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The Meaning of Saving and Investment
• National Saving
• National saving is the total income in the economy
that remains after paying for consumption and
government purchases.
• Private Saving
• Private saving is the amount of income that
households have left after paying their taxes and
paying for their consumption.
Private saving = (Y – T – C)
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The Meaning of Saving and Investment
• Public Saving
• Public saving is the amount of tax revenue that the
government has left after paying for its spending.
Public saving = (T – G)
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The Meaning of Saving and Investment
• Surplus and Deficit
• If T > G, the government runs a budget surplus
because it receives more money than it spends.
• The surplus of T - G represents public saving.
• If G > T, the government runs a budget deficit
because it spends more money than it receives in
tax revenue.
• For the economy as a whole, saving must be
equal to investment.
S = I
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THE MARKET FOR LOANABLE
FUNDS
• Financial markets coordinate the economy’s
saving and investment in the market for
loanable funds.
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THE MARKET FOR LOANABLE
FUNDS
• The market for loanable funds is the market in
which those who want to save supply funds and
those who want to borrow to invest demand
funds.
• Loanable funds refers to all income that people
have chosen to save and lend out, rather than
use for their own consumption.
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Supply and Demand for Loanable Funds
• Financial markets work much like other
markets in the economy.
• The equilibrium of the supply and demand for
loanable funds determines the real interest rate.
• The interest rate represents the amount that
borrowers pay for loans and the amount that lenders
receive on their saving.
Figure 1 The Market for Loanable Funds
Loanable Funds
(in billions of dollars)
0
Interest
Rate Supply
Demand
5%
$1,200
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Supply and Demand for Loanable Funds
• Government Policies That Affect Saving and
Investment
• Taxes and saving
• Taxes and investment
• Government budget deficits
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Policy 1: Saving Incentives
• Taxes on interest income substantially reduce
the future payoff from current saving and, as a
result, reduce the incentive to save.
Figure 2 An Increase in the Supply of Loanable
Funds
Loanable Funds
(in billions of dollars)
0
Interest
Rate
Supply, S1 S2
2. . . . which
reduces the
equilibrium
interest rate . . .
3. . . . and raises the equilibrium
quantity of loanable funds.
Demand
1. Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
$1,200
4%
$1,600
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Policy 1: Saving Incentives
• If a change in tax law encourages greater
saving, the result will be lower interest rates
and greater investment.
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Policy 2: Investment Incentives
• Suppose a tax reform aimed at making
investment more attractive
• E.g. investment tax credit – gives a tax
advantage to any firm building a new factory or
buying a new piece of equipment
Figure 3 An Increase in the Demand for
Loanable Funds
Loanable Funds
(in billions of dollars)
0
Interest
Rate
1. An investment
tax credit
increases the
demand for
loanable funds . . .
2. . . . which
raises the
equilibrium
interest rate . . .
3. . . . and raises the equilibrium
quantity of loanable funds.
Supply
Demand, D1
D2
5%
$1,200
6%
$1,400
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Policy 2: Investment Incentives
• If a change in tax laws encourages greater
investment, the result will be higher interest
rates and greater saving.
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Policy 3: Government Budget Deficits and
Surpluses
• When the government spends more than it
receives in tax revenues, the short fall is called
the budget deficit.
• The accumulation of past budget deficits is
called the government debt.
Figure 4: The Effect of a Government Budget
Deficit
Loanable Funds
(in billions of dollars)
0
Interest
Rate
3. . . . and reduces the equilibrium
quantity of loanable funds.
S2
2. . . . which
raises the
equilibrium
interest rate . . .
Supply, S1
Demand
$1,200
5%
$800
6%
1. A budget deficit
decreases the
supply of loanable
funds . . .
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Policy 3: Government Budget Deficits and
Surpluses
• When government reduces national saving by
running a deficit, the interest rate rises and
investment falls.
• This fall in investment is referred to as
crowding out.
• The deficit borrowing crowds out private borrowers
who are trying to finance investments.
• A budget surplus increases the supply of
loanable funds, reduces the interest rate, and
stimulates investment.
Figure 5 The U.S. Government Debt
Percent
of GDP
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990
Revolutionary
War
2010
Civil
War World War I
World War II
0
20
40
60
80
100
120
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Summary
• The financial system is made up of many types of
financial institutions – 2 categories
• Financial markets – the stock, bond market
• Financial intermediaries – banks, mutual funds
• All these institutions act to direct the resources of
households who want to save some of their income
into the hands of households and firms who want to
borrow.
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Summary
• National income accounting identities reveal
some important relationships among
macroeconomic variables.
• In particular, in a closed economy, national
saving must equal investment.
• National saving equals private saving plus
public saving.
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Summary
• The interest rate is determined by the supply
and demand for loanable funds.
• The supply of loanable funds comes from
households who want to save some of their
income.
• The demand for loanable funds comes from
households and firms who want to borrow for
investment.
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Summary
• A government budget deficit represents
negative public saving and, therefore, reduces
national saving and the supply of loanable
funds.
• When a government budget deficit crowds out
investment, it reduces the growth of
productivity and GDP.