Chapter 26 Financial System

Nguyen Thi Thuy VINH

Saving, Investment, and

the Financial System

Chapter 26 – Saving, Investment and the Financial System

I. Financial System

Financial markets

Saving Financial System Investment

Financial Intermediaries

Financial system consists of those institutions in the

economy that help to match one person’s saving with
another person’s investment.

I. Financial System

1. Financial markets: institutions through which

savers can directly provide funds to borrowers.

Examples:
– The Bond Market.
A bond is a certificate of indebtedness.
– The Stock Market.
A stock is a claim to partial ownership in a firm.
Firm sales stock to raise money => equity finance
Firm sales bond to raise money => debt finance

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Chapter 26 Financial System

I. Financial System
2. Financial intermediaries: institutions through
which savers can indirectly provide funds to
borrowers.
Examples:
– Banks : Take in deposits from people who want to
save and use these deposits to make loans to
people who want to borrow
– Mutual funds – institutions that sell shares to the
public and use the proceeds to buy portfolios of
stocks and bonds

When analyzing the macroeconomic role of the financial

system, it is more important keep in mind the similarity
of these institutions than the difference

These financial institutions all serve same goal: connecting

the resources of savers into the hands of borrowers

Assume: only one financial market

The Market for Loanable Funds

II. Some Important Identities

Identity is an equation that must be true because of the
way the variables in the equation are defined .
1. In the simple economy
Y is output of economy : income and expenditure
Y≡C+I and Y≡C+S => I ≡ Y- C ≡ S
=> I ≡ S
In simple economy investment is identically equal to
saving

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Chapter 26 Financial System

2. In closed economy
 Three Kinds of Saving
Private saving =
Public saving =

Budget surplus
= an excess of tax revenue over govt spending
= T–G = public saving
Budget deficit
= a shortfall of tax revenue from govt spending
= G–T = – (public saving)

2. In closed economy
 Three Kinds of Saving

National saving
= private saving + public saving
=
=
= the portion of national income that is not used
for consumption or government purchases

2. In closed economy
 National income accounting identity:
Y = C + I + G + NX
In closed economy:
Y=C+I+G
Solve for I:

Note: It does not have to be true for every individual household or firm

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Chapter 26 Financial System

NOW YOU TRY:

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, taxes, private saving, national
saving, and investment.

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NOW YOU TRY:

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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Private Saving vs. Investment

– Buy corporate bonds or equities

– Purchase a certificate of deposit at the bank
– General Motors spends $250 million to build
a new factory in Michigan.
– Buy shares of a mutual fund
– You buy $5000 worth of computer equipment for your
business.
– Let accumulate in saving or checking accounts
– Your parents spend $300,000 to have a new house
built.

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Chapter 26 Financial System

III. 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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III. The Market for Loanable Funds

• A supply-demand model of the financial system

• Helps us understand
- how the financial system coordinates saving &
investment
- how govt policies and other factors affect saving,
investment, the interest rate

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III. The Market for Loanable Funds

1. Supply and Demand for loanable funds

The Supply of loanable funds comes from Saving:

- Private saving:
- Public saving:

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Chapter 26 Financial System

III. The Market for Loanable Funds

1. Supply and Demand 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.

III. The Market for Loanable Funds

1. Supply and Demand for loanable funds

Price of loan:

Note:

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III. The Market for Loanable Funds

1. Supply and demand for loanable funds

 Higher r → saving more attractive → higher

quantity of loanable funds supplied

 Higher r → borrowing more expensive → lower
quantity of loanable funds demanded


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Chapter 26 Financial System

The Slope of the Supply Curve

An increase in the
Interest
Rate Supply
interest rate
makes saving
more attractive,
6%
which increases
the quantity of
loanable funds
3% supplied.

60 80 Loanable Funds
($billions)

The Slope of the Demand Curve

A fall in the interest rate
Interest reduces the cost of
Rate
borrowing, which
7% increases the quantity of
loanable funds
demanded.
4%

Demand

50 80 Loanable Funds
($billions)

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Equilibrium
The interest rate
Interest adjusts to equate
Rate Supply supply and demand.

The eq’m quantity

5% of L.F. equals eq’m
investment and
eq’m saving.
Demand

60 Loanable Funds
($billions)

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Chapter 26 Financial System

2. Government Policies
Taxes and saving
 Taxes and investment
 Government budget deficits

2. Government Policies

Policy 1: Saving Incentive

• Taxes on interest income substantially reduce the

future payoff from current saving and, as a result,
reduce the incentive to save.

Policy 1: Saving Incentive

Interest
Rate S1

10%

D1

60 Loanable Funds
($billions)

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Chapter 26 Financial System

2. Government Policies
Policy 2: Investment Incentive

Suppose that government give a tax reduction to any

firm building a new factory
 Investment tax credit => reward firms that invest
in new capital

 An investment tax credit increases the incentive

to borrow.

Policy 2: Investment Incentive

Interest
Rate S1

5%

D1

60 Loanable Funds
($billions)

NOW YOU TRY:

Exercise
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
budget runs from surplus to deficit.
– Draw the new curve on your diagram.
– What happens to the equilibrium values of the
interest rate and investment?

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Chapter 26 Financial System

Budget Deficits, Crowding Out,

and Long-Run Growth
• Our analysis: Increase in budget deficit causes
fall in investment.
The govt borrows to finance its deficit,
leaving less funds available for investment.
• This is called crowding out.
• Recall from the preceding chapter: Investment
is important for long-run economic growth.
Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
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