Chapter 8- Saving, Investment and the Financial System

Learning Objectives
 Learn about important Financial Institutions in the Canadian Economy
 Consider how financial system and its relation to key macroeconomic variables
 Develop a model of Supply and Demand of Loanable Funds in Financial Markets
 Use of loanable funds model to analyze various government policies
 Consider how Government Budget Deficits and Surpluses affect the Canadian Economy
Why is this Chapter important?
In Chapter 7, we learned that capital and labor are among the primary determinants of output. In the
current chapter, we will address the market for saving and investment in capital. Chapter 9 will
address the market for labor.
Canadian Financial System
Definition of Financial System: The group of institutions in the economy that help to match one
person’s saving with another person’s investment.
Two main Categories:
1. Financial Markets: Financial Institutions through which savers can directly provide funds to
borrowers.
a)The Bond Market
Bond- A Certificate of Indebtedness.
- Identifies maturity date and rate of interest that will be paid until maturity
- Term of the bond determines its value, term is the length of time until bond matures; All else
equal, longer term→ higher interest rate
- Credit Risk, the probability that the borrower will fail to pay some of the interest or principal. All
else equal, higher risk →higher interest rate
- The Canadian Govt. is considered a relatively safe credit risk, while provincial govts. and
Corporations are somewhat greater credit risk, interest rate higher.
- Sale of bond to raise money is called Debt Financing

b)The Stock Market

Stock- A claim to partial ownership in a firm.
- Sale of Stock to raise money is called Equity Financing
- Stocks are sold in organized Stock Exchanges such as the NYSE, NASDAQ and the TSX; prices
are determined by the Supply and Demand of Stocks.
- Price of Stock generally reflects the future profitability of the company
- A Stock Index is computed as an average of a group of stock prices
Financial Intermediaries: Institutions through which savers can provide funds to borrowers.
Banks
- Take deposits from savers and lend them to borrowers.
- Pay interest to depositors, charge interest rate from borrowers.
- Allow individuals to use chequing deposits to use as a medium of exchange.
Mutual Funds sell shares to the public and use funds to buy a portfolio of stocks and bonds.
- Primary Advantage It allows individuals with small amount holders to diversify.
- Index Funds buy all of the stocks of a given stock index; they generally perform better than
1
 funds with active funds managers probably because they trade stocks less frequently and they do
not have to pay salaries of fund managers.
Saving and Investment in the National Income Accounts
Some Important Identities:
Recall GDP Equation
Y = C + I + G + NX
Assume Closed Economy which means NX = 0
Y=C+I+G
Subtract C+G on both Sides
Y–C–G=I
Left hand side of the equation is total income after paying for consumption and government
expenditure. It’s called National Saving.

National Saving: Total income in the economy that remains after paying for consumption and
government purchases.
Substituting S for savings in the above identity tells us that saving equals investment.
S = I (For the Economy as a whole saving must equal investment)
Let’s go back to the definition of savings again:
S=Y–C-G
Add and subtract taxes (T) from the above equation gives us Private and Public Saving.
S = (Y – C – T) + (T – G)
Private Saving: The income that households have left after paying for taxes and consumption.
Public Saving: The tax revenue that government has left after paying for its spending.
Budget Surplus: An excess of tax revenue over government spending.
Budget Deficit: A short fall of tax revenue from government spending.

Important: with government budget deficit, public saving is negative i.e. public sector
is dis-saving. To make up for this shortfall, it will go to loanable funds market to borrow
money which reduces the supply of loanable funds for investment. Note: you might
think it should increase the demand for loanable funds but the way we have defined
the model, demand curve represents private investors only.
Finacial markets and financial institutions stand between the two sides of S and I equation. These
markets take the nation’s saving and direct it to nation’s investment.

Meaning of Saving and Investment: In Macroeconomics

Investment- Purchase of new capital, such as equipment or buildings
Saving- if an individual spends less than he earns and uses the rest to buy stocks or mutual funds,
economists call this saving.
jOutside economics, people use saving and investing interchangably.

The Market for Loanable Funds: the market in which those who want to save supply funds and
those who want to borrow for investment demand funds.

2
Supply and Demand for Loanable Funds
Supply – comes for those who spend less than they earn; it can occur directly through purchase of
stocks or bonds or indirectly through a financial intermediary. (S)
Demand – comes from households and firms who wish to borrow funds to make investments. HHs
generally invest in new homes, firms borrow for new equipment or to build factories. (I)
Price – Price of a loan is the interest rate.
-All else equal, as the interest rate increases, supply of loanable funds increases.
-All else equal, as the interest rate increases, demand for loanable funds decreases.
-Equality of demand and supply determines the interest rate.
-If the interest rate is higher than equilibrium, dd is smaller than supply. Lenders would compete for
borrowers, driving the interest rate down.
-If interest rate is lower than the equilibrium, dd is greater than ss. Shortage of loanable funds would
encourage borrowers to raise the interest rate.
-SS and DD for loanable funds depnd on the real rather than nominal interest rate because the real
interest rate reflects the true return on saving and the true cost of borrowing.
In order to see the effect of various policies on SS and DD for loanable funds, we will follow 3 steps:
1- Determine which curve is affected
2- Decide which way it will shift
3- Determine the policy effect on the equilibrium interest rate and qunatity of funds.
Policy 1: Saving Incentives
-Savings rates in Canada are relatively lower than Japan and Germany.
-Govt. change the tax laws to encourage people to contribute in RRSP, this will increase savings, SS
of loanable funds ↑
-Equilibrium interest rate will ↓ and equilibrium quantity will ↑
Policy 2: Investment Incentives
-Suppose Government passed a law to lower tax for any firm that builds a new factory or buys a new
piece of equipment (investment tax credit)
- This will cause an increase in investment, DD for loanable funds will shift to the right
- The equilibrium interest rate ↑ and the equilibrium quantity will also ↑
Note: Both policies increase saving and investment, the difference is the effect on interest rate.
Policy 3: Government Budget Deficits and Surpluses
Budget Deficit occurs when government spends more than it recieves in tax revenue (G > T),
-This implies that public saving (T-G) ↓ which means national saving ↓
-The SS of loanable funds will shift to the left
-Equilibrium interest rate ↑ and the equilibrium quantity ↓
-When interest rate ↑, dd for loanable funds for inestment ↓
Crowding Out: A decrease in investment that results from government borrowing.
When government reduces national saving by running budget deficit, interest rate ↑ and I ↓
Budget Surplus (G<T), an increase in public savings and national saving, SS of loanable funds curve
will shift to the right. Equilibrium interest rate ↓, and investment ↑
Vicious Circle: Deficit reduces SS of loanable funds, increases interest rates, discourage investment
→slower growth →lower tax revenue, more spending on income support programs → more deficit.