MACROECONOMICS I
Savings, Investment, and Financial System
Lecture 4
March 04, 2022
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LOOK FOR THE ANSWERS TO THESE
QUESTIONS:
• What are the main types of financial institutions
in the U.S. economy, and what is their function?
• What are the three kinds of saving?
• What’s the difference between saving and
investment?
• How does the financial system coordinate saving
and investment?
• How do government policies affect saving,
investment, and the interest rate? 2
FINANCIAL INSTITUTIONS
Financial system
 Group of institutions in the economy that help
match the saving of one person with the
investment of another
Financial institutions
 Institutions through which savers can provide
funds to borrowers
 Financial markets
 Financial intermediaries
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FINANCIAL MARKETS
Savers can directly provide funds to borrowers
 The bond market:
➢ A bond is a certificate of indebtedness
 The stock market:
➢ A stock is a claim to partial ownership in a
firm
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FINANCIAL INTERMEDIARIES
Institutions through which savers can indirectly
provide funds to borrowers
 Banks
 Mutual funds: institutions that sell shares to
the public and use the proceeds to buy
portfolios of stocks and bonds
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ACCOUNTING IDENTITIES
Gross domestic product (GDP, Y)
 Total income = Total expenditure
Y = C + I + G + NX
• Y = gross domestic product, GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports
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ACCOUNTING IDENTITIES
Assume closed economy: NX = 0
Y = C + I + G, so I = Y – C - G
National saving (saving), S
• Total income in the economy that remains after
paying for consumption and government
purchases
 By definition: S = Y – C – G
It follows: Saving (S) = Investment (I) for a
closed economy 10
ACCOUNTING IDENTITIES
 For T = taxes minus transfer payments
S = Y – C – G can be rewritten as:
S = (Y – T – C) + (T – G)
Private saving, Y – T – C
 Income that households have left after paying for
taxes and consumption
Public saving, T – G
 Tax revenue that the government has left after
paying for its spending 11
ACCOUNTING IDENTITIES
Budget surplus: T – G > 0
 Excess of tax revenue over government
spending = public saving (T-G)
Budget deficit: T – G < 0
 Shortfall of tax revenue from government
spending = – (public saving) = G – T
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ACTIVE LEARNING 1 A. CALCULATIONS
Suppose GDP equals $10 trillion, consumption equals
$6.5 trillion, the government spends $2 trillion and
has a budget deficit of $300 billion.
Find:
• public saving,
• net taxes,
• private saving,
• national saving,
• investment.
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ACTIVE LEARNING 1 A. ANSWERS
Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3 (all
in trillions)
• Public saving = T – G = – 0.3
• Net taxes: T = G – 0.3 = 1.7
• Private saving = Y–T–C = 10 – 1.7 – 6.5 = 1.8
• National saving S = Y–C–G = 10 – 6.5 – 2 = 1.5
• Investment = national saving = 1.5
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ACTIVE LEARNING 1 B. HOW A TAX CUT AFFECTS SAVING
Use the numbers from the preceding exercise,
but suppose now that the government cuts taxes by
$200 billion.
In each of the following two scenarios, determine
what happens to public saving, private saving,
national saving, and investment.
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend the
other 3/4.
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ACTIVE LEARNING 1 B. ANSWERS
In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged, so investment is
unchanged.
2. If consumers save $50 billion and spend $150
billion, then national saving and investment each
fall by $150 billion.
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ACTIVE LEARNING 1 C. DISCUSSION QUESTIONS
The two scenarios from this exercise were:
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend
the other 3/4.
Which of these two scenarios do you think is more
realistic?
Why is this question important?
THE MEANING OF SAVING AND INVESTMENT
Private saving
 Income remaining after households pay their
taxes and pay for consumption.
 Examples of what households do with saving:
➢ Buy corporate bonds or equities
➢ Purchase a certificate of deposit at the bank
➢ Buy shares of a mutual fund
➢ Let accumulate in saving or checking accounts
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THE MEANING OF SAVING AND INVESTMENT
Investment
 Is the purchase of new capital
 Examples of investment:
➢ General Motors spends $250 million to build
a new factory in Michigan.
➢ You buy CZK 200000 worth of computer
equipment for your business.
➢ Your parents spend €300,000 to have a new
house built.
Investment is NOT the purchase of stocks and bonds!19
THE MARKET FOR LOANABLE FUNDS
Loanable funds market
 A supply–demand model of the financial
system
 Helps us understand:
➢ How the financial system coordinates
saving & investment.
➢ How government policies and other factors
affect saving, investment, the interest rate.
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THE MARKET FOR LOANABLE FUNDS
Assume: only one financial market
 All savers deposit their saving in this market.
 All borrowers take out loans from this market.
 There is one interest rate, which is both the
return to saving and the cost of borrowing.
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THE MARKET FOR LOANABLE FUNDS
The supply of loanable funds comes from saving:
 Households with extra income can loan it out
and earn interest.
 Public saving
➢ If positive, adds to national saving and the
supply of loanable funds.
➢ If negative, it reduces national saving and
the supply of loanable funds.
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THE SLOPE OF THE SUPPLY CURVE
An increase in the
interest rate makes
saving more attractive,
which increases the
quantity of loanable
funds supplied.
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Interest
Rate
Loanable Funds
($billions)
Supply
60
3%
80
6%
THE MARKET FOR LOANABLE FUNDS
The demand for loanable funds comes from
investment:
 Firms borrow the funds they need to pay for
new equipment, factories, etc.
 Households borrow the funds they need to
purchase new houses.
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THE SLOPE OF THE DEMAND CURVE
A fall in the interest rate
reduces the cost of
borrowing, which
increases the quantity of
loanable funds
demanded.
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Interest
Rate
Loanable Funds
($billions)
Demand
50
7%
4%
80
EQUILIBRIUM
The interest rate adjusts to
equate supply and demand.
The equilibrium quantity of
loanable funds equals
equilibrium investment and
equilibrium saving.
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Interest
Rate
Loanable Funds
($billions)
Demand
Supply
5%
60
POLICY 1: SAVING INCENTIVES
Tax incentives for saving
increase the supply of
loanable funds
…which reduces the
equilibrium interest rate
and increases the
equilibrium quantity of
loanable funds
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Interest
Rate
Loanable Funds
($billions)
D1
S1
5%
60
S2
4%
70
POLICY 2: INVESTMENT INCENTIVES
An investment tax
credit increases the
demand for loanable
funds
…which raises the
equilibrium interest rate
and increases the
equilibrium quantity of
loanable funds
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Interest
Rate
Loanable Funds
($billions)
D1
S1
5%
60
6%
70
D2
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ACTIVE LEARNING 2 BUDGET DEFICITS
Use the loanable funds model to analyze
the effects of a government budget deficit:
• Draw the diagram showing the initial equilibrium.
• Determine which curve shifts when the government
runs a budget deficit.
• Draw the new curve on your diagram.
• What happens to the equilibrium values of the
interest rate and investment?
ACTIVE LEARNING 2 ANSWERS
A budget deficit
reduces national saving
and the supply of
loanable funds
…which increases the
equilibrium interest rate
and decreases the
equilibrium quantity of
loanable funds and
investment.
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Interest
Rate
Loanable Funds
($billions)
D1
S1
5%
60
S2
6%
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BUDGET DEFICITS, CROWDING OUT,
AND LONG-RUN GROWTH
Our analysis:
 Increase in budget deficit causes fall in investment
 The government borrows to finance its deficit,
leaving less funds available for investment:
crowding out
Investment is important for long-run economic growth
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ASK THE EXPERTS
Fiscal Policy and Saving
“Sustained tax and spending policies that boost
consumption in ways that reduce the saving rate
are likely to lower long-run living standards.”
THE U.S. GOVERNMENT DEBT
The government finances deficits by borrowing (selling
government bonds).
 Persistent deficits lead to a rising government debt.
The ratio of government debt to GDP
 Useful measure of the government’s indebtedness
relative to its ability to raise tax revenue.
 Historically, the debt-GDP ratio usually rises during
wartime and falls during peacetime—until the early
1980s.
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U.S. GOVERNMENT DEBT AS A PERCENTAGE OF GDP 1790–2012
CONCLUSION
Financial markets: governed by the forces of supply
and demand
 Help allocate the economy’s scarce resources to their
most efficient uses.
 Link the present to the future
➢ Savers: convert current income into future
purchasing power
➢ Borrowers: acquire capital to produce goods
and services in the future
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SUMMARY
• The financial system is made up of many types of
financial institutions, like the stock and bond
markets, banks, and mutual funds.
• National saving equals private saving plus
public saving.
• In a closed economy, national saving equals
investment. The financial system makes this
happen.
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SUMMARY
• The supply of loanable funds comes from saving.
The demand for funds comes from investment. The
interest rate adjusts to balance supply and
demand in the loanable funds market.
• A government budget deficit is negative public
saving, so it reduces national saving, the supply of
funds available to finance investment.
• When a budget deficit crowds out investment,
it reduces the growth of productivity and GDP.
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