Lecture 6 Saving and Investment (Student)

PARKIN
MACROECONOMICS
Thirteenth Edition, Global Edition
7 FINANCE, SAVING,
AND INVESTMENT
After studying this chapter, you will be able to:
 Describe the flow of funds in financial markets
 Explain how financial decisions are made and the risks

that arise from these decisions
 Explain how lending and borrowing decisions interact in

financial markets
 Explain how governments influence financial markets
© 2019 Pearson Education Ltd.

Financial Markets and Financial Institutions
To study the economics of financial institutions and

markets we distinguish between
 Finance and money
 Physical capital and financial capital
Finance and Money
The study of finance looks at how households and firms
obtain and use financial resources and how they cope with
the risks that arise in this activity.
The study of money looks at how households and firms
use it, how much of it they hold, how banks create and
manage it, and how its quantity influences the economy.

Physical Capital and Financial Capital

Physical capital is the tools, instruments, machines,
buildings, and other items that have been produced in the
past and that are used today to produce goods and
services.
The funds that firms use to buy physical capital are called
financial capital.

Capital and Investment

Gross investment is the total amount spent on purchases
of new capital and on replacing depreciated capital.
Depreciation is the decrease in the quantity of capital that
results from wear and tear and obsolescence.
Net investment is the change in the quantity of capital.
Net investment = Gross investment  Depreciation.

Figure 7.1 illustrates the

relationships among the
capital, gross investment,
depreciation, and net
investment.
Net investment =
Gross investment  Depreciation

Wealth and Saving
Wealth is the value of all the things

that people own.
Saving is the amount of income

that is not paid in taxes or spent on
consumption goods and services.
 Thus, saving increases wealth.

 Wealth also increases when the market value of assets
rises—called capital gains—and decreases when the
market value of assets falls—called capital losses. (e.g.
house)
Financial Capital Markets
SAVING is the source of

funds used to finance
investment
these funds are supplied
and demanded in three
types of financial markets:
Loan
markets Stock
Bond markets
markets

Financial Institutions
A financial institution is a firm that operates on both
sides of the markets for financial capital.
Lender in
Borrower in Financial another
one market Institutions market
 Commercial banks
 Government-sponsored mortgage lenders
 Mutual funds and Pension funds
 Insurance companies
The Federal Reserve

Where do the funds that finance
investment come from?
The circular flow model of Chapter 4 (pg. 125).
Loanable Funds come from three sources:
1. Household saving (S)
2. Government budget surplus (T – G)
3. Borrowing from the rest of the world (M – X)
Figure 7.2 on the next slide illustrates the flows of funds

that finance investment.


Financial Decisions and Risk
Due to the scarce resources, how do we make the
financial decision and manage the investment risk at the
right time?
The Time Value of Money
We need to compare current and future dollars by

converting the “future value” to “present value.”
Present value of an amount of money n years in the
future when the interest rate is r percent:
𝑭𝒖𝒕𝒖𝒓𝒆 𝒗𝒂𝒍𝒖𝒆
Present value =
(𝟏+𝒓)𝒏

Example:
.
If the interest rate is 10% a year, what is the present

value of $100 investment in 10 years?
Present value of $100, in 10 years
𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒
=
(1+𝑟)𝑛
= $100/(1+0.1)10
= $100/2.59374
= $38.55
If $38.55 is invested today at 10% interest a year, it will

accumulate to $100 in 10 years.

Net Present Value
Net present value is the present value of all the future
flows of money that arise from a financial decision minus
the initial cost of the decision.
Example:
Jack can make a game bot for $500 and sell it after two
years for $2,420. The interest rate is 10 percent a year.
The present value = $2,420/(1 + 0.1)2 = $2,000.
The net present value = $2,000 – $500 = $1,500.
10% interest rate
=10/100=0.1
The financial decision rule (to maximize the wealth) is
If the net present value is positive Do it!
Don’t
If the net present value is negative
do it!
However, when the future is risky or uncertain, the rule is

modified to:
Do it if the net present value is large enough to make
a loss sufficiently unlikely

Financial Risk: Insolvency and Illiquidity
A financial institution’s net worth is the total market value
of what it has lent minus the market value of what it has
borrowed.
If net worth is positive, If net worth is negative,

the institution is solvent. the institution is insolvent.
Can remain in the Should go out of the
business business

Financial Decisions and Market Risk
• Stocks, bonds and short-term securities and loans are
called financial assets.
• The interest rate on a financial asset is the dollar amount
earned expressed as a proportion of the price of the asset.
• An asset price and the interest rate are inversely related.
Example:
if the price of the asset is $50 and the interest is $5, then the
interest rate is 10 percent.
If the asset price rises (say to $200), other things remaining
the same, the interest rate falls (2.5 percent).
If the asset price falls (say to $20), other things remaining the
same, the interest rate rises (to 25 percent).
Interest Rates
An economy with inflation has two interest rates:
The nominal interest rate and the real interest rate.
1. Nominal Interest Rate 2. Real Interest Rate
Nominal interest rate is the number of dollars that a

borrower pays and a lender receives in interest in a year
expressed as a percentage of the number of dollars
borrowed and lent.
Example:
If the annual interest paid on a $500 loan is $25, the nominal
interest rate is 5 percent per year.

Real interest rate is the nominal interest rate adjusted to

remove the effects of inflation on the buying power of
money.
Real interest rate ≈ nominal interest rate - inflation rate.
Example:
If the nominal interest rate is 5 percent a year and the
inflation rate is 2 percent a year, the real interest rate is
3 percent (5% - 2%)a year.
The real interest rate is the opportunity cost of borrowing
and lending.
The Loanable Funds Market
The loanable funds market is the aggregate of all the

individual financial markets.
We are going to see how the loanable funds market
determines the
• real interest rate
• quantity of funds loaned
• saving
• Investment

The Quantity of Loanable Funds Demanded depend on
Real interest Expected

rate profit
Demand for Loanable Funds Curve

The demand for loanable funds is the relationship
between the quantity of loanable funds demanded and the
real interest rate when all other influences on borrowing
plans remain the same.
Real
Interest
Rate
loanable fund
Figure 7.3 shows the
demand for loanable funds
curve.
A rise in the real interest
rate decreases the quantity
of loanable funds
demanded.
A fall in the real interest rate
increases the quantity of
loanable funds demanded.

The Demand Loanable Funds (DLF)
When the *expected profit changes, Real

the demand for loanable funds changes. interest
rate
DLF0 DLF1
Other things remaining the same,
loanable fund
The The greater

greater the the demand
The
expected for loanable
greater the
profit from fund - shift
amount of
new the DLF
investment
capital curve to the
right.

The Supply Loanable Funds (SLF)
The supply of loanable funds is the relationship between

the quantity of loanable funds supplied and the real
interest rate when all other influences on lending plans
remain the same.
SLF
Real
Interest
Rate
loanable fund
*Saving is the main item that makes up the supply of

loanable funds.

Figure 7.4 shows the supply

of loanable funds curve.
A rise in the real interest rate
increases the quantity of
loanable funds supplied.
A fall in the real interest rate
decreases the quantity of
loanable funds supplied.

Shifts of the Supply of Loanable Funds
Any change in the four factors:
change in disposable income Will cause a
expected future income shift in the
wealth supply
default risk loanable funds
curve
Example: An increase in disposable income, a decrease in

expected future income, a decrease in wealth, or a fall in
default risk increases saving and increases the supply of
loanable funds.

The Supply Loanable Funds (SLF)
SLF0
SLF1
Real
1. Real interest
interest rate
rate
loanable fund
2.
5. Disposable • Increase in disposable
Default Quantity of income income
risk loanable • Decrease in wealth
funds decrease
• Decrease in default risk
supplied • Decrease in expected
future income
3.
Expected
4. Wealth
future
income

Equilibrium in the Loanable Funds Market
The loanable funds market is in equilibrium at the

real interest rate at which the quantity of loanable
funds demanded equals the quantity of loanable
funds supplied.

Figure 7.5 illustrates the loanable
funds market.
At 7% a year, there is a
surplus of loanable funds
and the real interest rate
falls.
At 5% a year, there is a
shortage of loanable funds
and the real interest rate
rises.
Equilibrium occurs at a real
interest rate of 6% a year.

Changes in Demand and Supply
Financial markets are highly volatile in the short run but
remarkably stable in the long run.
Fluctuations in Demand for
loanable funds
Volatility
Fluctuations in Supply for the
loanable funds
These fluctuations bring fluctuations in the real interest

rate and in the equilibrium quantity of funds lent and
borrowed. They also bring fluctuations in asset prices.

Shirt in Demand Loanable Funds curve
Figure 7.6(a) illustrates an

increase in the demand for
loanable funds.
An increase in expected profits
increases the demand for
funds shift the DLF0 to DLF1.
Supply does not change.
The real interest rate rises –
encourage saving.
Thus, saving and quantity of
funds supplied increases.

Shift in Supply Loanable Funds curve
Figure 7.6(b) illustrates an
increase in the supply of loanable
funds.
If one of the influences on
saving plans changes and
saving increases, the supply of
funds increases shift the SLF0
to SLF1.
Demand does not change.
The real interest rate falls,
encourage investors borrow
more for more investment.
Thus, Investment increases.

Shift in Supply Loanable Funds curve
In 2008, financial and housing SLF1
crisis occurred in U.S.

During housing bubbles,
many people are unable to
pay their housing loan.
As a results, supply of fund
decrease. Supply loanable
funds shifts from the SLF0 to
SLF1.
The real interest rate rise.

Government in the Loanable Funds
Market
Government enters the loanable funds market when it

has a budget surplus or deficit.
 A government budget surplus increases the supply

of funds.
 A government budget deficit increases the demand
for funds.

Market
Figure 7.7 illustrates the effect of
a government budget surplus.
A government budget surplus

increases the supply of funds.
Shift the PSLF (private SLF) to
SLF.
The real interest rate falls from
6% to 5%.
Private saving decreases to
$1.5 trillion, but Investment
increases to $2.5 trillion.

Market (Crowding-Out Effect)
Figure 7.8 illustrates the
effect of a government
budget deficit.
A government budget deficit
increases the demand for
funds, demand curve shifts to
the right from PDLF to DLF.
Supply does not change.
The real interest rate rises
and saving increases but
Investment decreases – a
crowding-out effect.

Government in the Loanable Funds Market
(Crowding-Out Effect)
• Crowding-Out effect is the tendency for a

government budget deficit to raise the real
interest rate and decrease investment.
• Crowding-Out effect does not decrease the
investment by full amount of the government
budget deficit because a higher real interest
rate induces an increase in private saving that
partly contributes toward financing the deficit

Government in the Loanable Funds Market
(Ricardo-Barro Effect)
A budget deficit increases the
demand for loanable funds.
Taxpayers are rational and can
foresee the budget deficit today
means that future taxes must be
higher and future disposable income
smaller. Thus, they increase saving
today, which increases the supply of
funds.
The private supply of loanable funds
increases to match the quantity of
loanable funds demanded by
government.
So the budget deficit has no effect
on both real interest rate and
investment. Crowding-out is
avoided.

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PARKIN

 Describe the flow of funds in financial markets

 Explain how financial decisions are made and the risks

 Explain how lending and borrowing decisions interact in

 Explain how governments influence financial markets

© 2019 Pearson Education Ltd.

To study the economics of financial institutions and

© 2019 Pearson Education Ltd.

Physical Capital and Financial Capital

© 2019 Pearson Education Ltd.

Capital and Investment

© 2019 Pearson Education Ltd.

Figure 7.1 illustrates the

© 2019 Pearson Education Ltd.

Wealth is the value of all the things

Saving is the amount of income

 Thus, saving increases wealth.

SAVING is the source of

© 2019 Pearson Education Ltd.

© 2019 Pearson Education Ltd.

Figure 7.2 on the next slide illustrates the flows of funds

© 2019 Pearson Education Ltd.

© 2019 Pearson Education Ltd.

We need to compare current and future dollars by

© 2019 Pearson Education Ltd.

If the interest rate is 10% a year, what is the present

If $38.55 is invested today at 10% interest a year, it will

© 2019 Pearson Education Ltd.

If the net present value is positive Do it!

However, when the future is risky or uncertain, the rule is

© 2019 Pearson Education Ltd.

If net worth is positive, If net worth is negative,

© 2019 Pearson Education Ltd.

1. Nominal Interest Rate 2. Real Interest Rate

Nominal interest rate is the number of dollars that a

© 2019 Pearson Education Ltd.

Real interest rate is the nominal interest rate adjusted to

Real interest rate ≈ nominal interest rate - inflation rate.

The loanable funds market is the aggregate of all the

© 2019 Pearson Education Ltd.

Real interest Expected

Demand for Loanable Funds Curve

© 2019 Pearson Education Ltd.

When the *expected profit changes, Real

The The greater

© 2019 Pearson Education Ltd.

The supply of loanable funds is the relationship between

*Saving is the main item that makes up the supply of

© 2019 Pearson Education Ltd.

Figure 7.4 shows the supply

© 2019 Pearson Education Ltd.

Example: An increase in disposable income, a decrease in

© 2019 Pearson Education Ltd.

© 2019 Pearson Education Ltd.

Equilibrium in the Loanable Funds Market

The loanable funds market is in equilibrium at the

© 2019 Pearson Education Ltd.

© 2019 Pearson Education Ltd.

These fluctuations bring fluctuations in the real interest

© 2019 Pearson Education Ltd.

Figure 7.6(a) illustrates an

© 2019 Pearson Education Ltd.

© 2019 Pearson Education Ltd.

In 2008, financial and housing SLF1