Econ 115

Lecture 5

Presented by Joshua F. Boitnott, PhD

Savings & Investment
• There are two kinds of people in the world:
- Those with “too much” money
⇒ lenders (or savers)
- Those with “too little” money
⇒ borrowers (or often investors)
• But lenders don't give out money for free since it is a scarce resource
- In other words, money has a price and the price for (holding) money is
interest rate.
- The interest rate helps determine how saving and investing take place in an
economy!
Savings & Investment
• The overall economy’s savings is not like your household’s saving.
• Think back to our definition of GDP: GDP equals total spending on
domestically produced final goods and services:
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑋 – 𝐼𝑀
- 𝐶 is spending by consumers.
- 𝐼 is investment spending.
- 𝐺 is government purchases of goods and services.
- 𝑋 is exports to other countries.
- 𝐼𝑀 is imports from other countries.
• In a closed economy, 𝑋 = 0 and 𝐼𝑀 = 0 giving:
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺
Savings & Investment
• Based on the relationship: Total Income = Total Spending
- Income can either be spent on consumption—consumer spending (𝐶) plus
government purchases of goods and services (𝐺)—or saved (𝑆):
- Total Income = Consumption Spending + Savings
𝐺𝐷𝑃 = 𝐶 + 𝐺 + 𝑆
• Reminder/Note: Savings is future consumption or delayed consumption.
- Alternatively, Total Income = Consumption Spending + Investment Spending:
𝐺𝐷𝑃 = 𝐶 + 𝐺 + 𝐼
• Still sounds a lot like household saving… you claimed it was different.
Savings & Investment
• First, important relationship: Savings–Investment Spending Identity
- Savings and investment spending are always equal for the economy as a
whole.
• Total income = Consumption spending + Savings AND
Total income = Consumption spending + Investment spending
- Putting these equations together, we get:
𝐶 + 𝐺 + 𝑆 = 𝐶 + 𝐺 + 𝐼
- Subtracting (𝐶 + 𝐺) from both sides, we get:
𝑆 = 𝐼
- Or Savings = Investment Spending!
The Financial System:
National Income Accounts
• What does that mean?
• National Saving (𝑆) is the total income that remains after paying for
consumption and government purchases
𝐺𝐷𝑃 − 𝐶 − 𝐺 ≡ 𝐼

𝑆 =𝐼
• Alternatively, we can write this as:
National Savings: 𝑆𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 = 𝑆𝑃𝑟𝑖𝑣𝑎𝑡𝑒 + 𝑆𝑃𝑢𝑏𝑙𝑖𝑐

Only Households and Government are included in National Saving!

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Savings & Investment
• We need to consider how the government being able to save influences
national savings.
- Let 𝑇 denote the taxes collected by the government and let Tr be the transfer
payments distributed by the government. We can express national saving as:
𝑆 = 𝐺𝐷𝑃 − 𝐶 − 𝐺 + (𝑇 − 𝑇 + 𝑇𝑟 − 𝑇𝑟)
𝑆 = 𝐺𝐷𝑃 − 𝑇 + 𝑇𝑟 − 𝐶 + (𝑇 − 𝑇𝑟 − 𝐺)
• Where
- 𝐺𝐷𝑃 − 𝑇 + 𝑇𝑟 − 𝐶 is the private savings: income and transfers that households
have left after paying for taxes and consumption
- 𝑇 − 𝑇𝑟 − 𝐺 is the public savings: tax revenue that remains after the government
pays for its transfers and spending

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Savings & Investment
• Government budget has a surplus if tax revenue is greater than its
spending:
𝑇 > 𝑇𝑟 + 𝐺 or 𝑆𝑝𝑢𝑏𝑙𝑖𝑐 > 0
• Government budget has a deficit if tax revenue is smaller than its
spending:
𝑇 < 𝑇𝑟 + 𝐺 or 𝑆𝑝𝑢𝑏𝑙𝑖𝑐 < 0
- Government Borrowing is the amount of funds borrowed by federal,
provincial, and local governments in the financial markets
• Government Debt is the sum of past budget deficits and surpluses
- Notice the difference in meaning between debt and deficit.

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Savings & Investment
• In an open economy, goods and money flow into and out of the country.
- A country can receive inflows of funds—foreign savings that finance investment
spending in that country.
- A country can also generate outflows of funds—domestic savings that finance
investment spending in another country.
• Net Foreign Investment (NFI): the outflow of funds minus the inflow of
funds.
- If NFI is negative, foreigners invest more in a country than that country invests in
other countries.
- In 2019, for example, net foreign investment in Canada was −$38.9 billion, meaning
that foreigners invested $38.9 billion more in Canada than Canadians invested
abroad.
Savings & Investment
• If a country spends more on imports than it earns from exports, it
must borrow the difference from foreigners.
- Net foreign investment = Exports − Imports
𝑁𝐹𝐼 = 𝑋 – 𝐼𝑀
• With an Open Economy have: 𝐺𝐷𝑃 = 𝐶 + 𝐺 + 𝐼 + (𝑋 − 𝐼𝑀)
- Rearrange it to
𝐺𝐷𝑃 − 𝐶 − 𝐺 = 𝐼 + (𝑋 − 𝐼𝑀)
- Since (𝐺𝐷𝑃 − 𝐶 − 𝐺) is equal to national savings, this gives:
𝑆𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 = 𝐼 + 𝑁𝐹𝐼
- Or the National Savings = Investment + Net Foreign Investment
Savings & Investment
• Canadian investment
spending was financed
by private savings and
capital inflow, which
were partially offset by
a government budget
deficit.
• German investment
spending was financed
by private savings and
a small budget surplus
but was offset by a
capital outflow.
Savings & Investment
Practice Question 1
• Net Foreign Investment is the:
a) net outflow of foreign funds plus domestic savings into an
economy.
b) the outflow of domestic funds to other countries minus the
inflow of foreign funds into the country.
c) the inflow of foreign funds into the country minus the outflow of
domestic funds to other countries.
d) total outflow of domestic funds to other countries plus the net
inflow of foreign funds into a country.
Savings & Investment
Practice Question 2
• Suppose a country exports $50 million worth of goods and services,
while it imports $60 million worth of goods and services. This country
a) has a positive net foreign investment.
b) lends funds to foreigners.
c) has a negative net foreign investment.
d) Answers (a) and (b) are both correct.
e) Answers (b) and (c) are both correct.
Savings & Investment
• On any given day, the people with money to lend are not usually the
same as people who want to borrow.
• Question: How are savers and borrowers brought together?
- Financial markets channel the savings of households to businesses that want
to borrow in order to purchase capital equipment.
- There are many financial markets. For our purposes we’ll assume there’s just
one market that brings savers and borrowers together.
- The Loanable Funds Market: a hypothetical market that illustrates the market
outcome of the demand for funds generated by borrowers and the supply of
funds provided by lenders
Savings & Investment
• We assume the price of loans is the (nominal) interest rate.
- Again, we assume a simplified world with just one interest rate, knowing that
the real world contains many interest rates according to length of loan, risk,
and customers.
- An investment is worth making only if it generates a future return that is
greater than the monetary cost of making the investment today.
- Present Value (𝑃𝑉) is the amount of money needed today to receive a given
amount of money at a future date given the interest rate.
• If you need $1,000 in a year and the interest rate on savings is 𝑟, how much do you need
to put in the bank now (𝑋)?
• 𝑋 × (1 + 𝑟) = $1,000. Rearrange: 𝑋 = $1,000/(1 + 𝑟).
• Or: 𝑃𝑉 = 𝐹𝑉/(1 + 𝑟) where 𝐹𝑉 is future value.
Savings & Investment
• Consider the following example: A firm has two potential investment
projects, each of which will yield $1,000 a year from now.
- One project requires that the firm borrow $900.
- The other requires that the firm borrow $950.
• Which (if any) of these projects is worth borrowing money to finance
and undertake?
- It depends on the interest rate.
- When the interest rate is 10%, then this means $1,000 in one year is worth
$909 today!
- Only the first project is worth it, since its initial cost ($900) is less than the
present value of $909.
- More projects become worthwhile as the interest rate falls.
Savings & Investment
• The interest rate measures the
opportunity cost of investment Figure 10-2
spending.
- The lower the interest rate, the less
attractive it is to put money into the bank.
- The lower the interest rate, the more
projects firms want to carry out, the higher
the quantity of loanable funds demanded.
- That’s why the demand curve for loanable
funds is downward sloping.
- Think of Demand as “Investment Curve”
Savings & Investment
• Why does the supply of loanable Figure 10-3

funds curve slope upward?

- Loanable funds are supplied by
savers.
- By saving money today and earning
interest, savers are rewarded with
higher consumption in the future.
- More people are willing to forgo
current consumption and make a
loan to a borrower when the
interest rate is higher.
Savings & Investment
• The Equilibrium Interest Rate: the interest rate at which the quantity
of loanable funds supplied equals the quantity of loanable funds
demanded.
• The market for loanable funds matches up desired savings with
desired investment spending.
• This match-up is efficient since:
- Right investments get made: projects with higher payoffs get financed.
- Right people do the saving and lending: those who are willing to lend for
lower interest rates get to save and lend.
 Savings & Investment
Figure 10-4

The equilibrium
interest rate, 𝑟 ∗ , and
the total quantity of
lending, 𝑄∗ , are
determined by the
intersection of the
supply and demand
curves, at point E.
Savings & Investment
Figure 10-5
• Factors that can cause the
demand curve for loanable
funds to shift:
- Changes in perceived business
opportunities
- Changes in government
policies
- In general, these a changes
that affect profits firms expect
to make!
Savings & Investment
Figure 10-6
• Factors that can cause the
supply curve for loanable
funds to shift:
- Changes in private savings
behaviour
- Changes in government
budget balance
• When the government runs a
budget surplus, public savings is
positive.
• When it runs a budget deficit,
public savings is negative.
Savings & Investment
• Capital flows from countries with low interest rates to countries with
high interest rates.
- Capital flows raise interest rates where they were low and reduce rates where
they were high.
• When international capital flows are so large that they equalize
interest rates across countries, there is a global loanable funds
market.
• Consider a simple two country example:
- Canada has an interest rate of 6% while Britain has an interest rate of 2%
without trade, what happens if trade is allowed?
Savings & Investment
• Anything that shifts either the supply of loanable funds curve or the
demand for loanable funds curve changes the interest rate.
• Major changes in interest rates have been driven by many factors,
including:
- Changes in government policy
- Technological innovations that created new investment opportunities
- Most importantly, people’s expectations about future inflation
• Real Interest Rate = Nominal Interest Rate – Inflation rate
- The true cost of borrowing (and payoff to lending) is the real interest rate.
- But neither lenders nor borrowers know what inflation will be, so loan contracts
specify a nominal interest rate.
- All figures above are drawn with the vertical axis measuring the nominal interest
rate for a given expected future inflation rate.
Savings & Investment
• One important issue is real interest rates can be negative
- Real Interest Rate = Nominal Interest Rate – Inflation rate or:
𝑖 = 𝑟 − 𝜋 if 𝑟 < 𝜋 ⇒ 𝑖 < 0
- Note: shows a negative interest rates!
- What does a negative interest rate mean?
• It means banks are charging people for depositing
money; or look at it in another way, banks are
paying people to take out loans
• Generally negative interest rates reflect
policy-maker’s desire to stimulate investment

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Savings & Investment
• According to the Fisher Effect, an increase in expected future inflation
drives up the nominal interest rate, leaving the expected real interest
rate unchanged. Figure 10-9

• In other words: 𝑟 = 𝑖 + π𝑒
- In equilibrium the nominal interest
rate increased by expected inflation,
but the equilibrium quantity of
loanable funds did not change!
- If the tide rises, these boats will
still float on the surface.
Savings & Investment
• Changes in expected
inflation and changes
in expected returns
move interest rates:
- During the 1970s,
inflation shot up, and
the expectations of
even higher inflation
raised interest rates.
- During the 2000s,
expectations of low
returns pushed the
interest rates down