SAVING, INVESTMENT, AND

23 THE FINANCIAL SYSTEM

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

Ø some of the important financial institutions in the economy.

Ø how the financial system is related to key macroeconomic variables.

Ø the relationship between present value and future value.

Ø the effects of compound growth.

Ø how risk-averse people reduce the risk they face.

Ø how asset prices are determined.

Ø the model of the supply and demand for loanable funds in financial markets.

Ø how to use the loanable funds model to analyze various government policies.

Ø how government budget deficits affect the economy.

CONTEXT AND PURPOSE:

Chapter 23 is the first chapter in a three-chapter sequence on interest rates, money and prices in the
long run. Chapter 23 addresses the market for saving and investment in capital and the tools people
and firms use when choosing capital projects in which to invest. Chapter 24 looks at the monetary
system and the last chapter in this section deals with open-economy macroeconomics.

The purpose of Chapter 23 is to show how the loanable funds market coordinates saving and
investment. Within the framework of the loanable funds market, we are able to see the effects of taxes
and government deficits on saving, investment, the accumulation of capital, and ultimately, the growth
rate of output. We will also show how people compare different sums of money at different points in
time, how they manage risk, and how these concepts combine to help determine the value of a
financial asset, such as a share of stock.
KEY POINTS:
1. Because savings can earn interest, a sum of money today is more valuable than the same sum of
money in the future. A person can compare sums from different times using the concept of present
value. The present value of any future sum is the amount that would be needed today, given
prevailing interest rates, to produce that future sum.

2. Because of diminishing marginal utility, most people are risk averse. Economic agents can reduce
risk using insurance, through diversification, and by choosing a portfolio with lower risk and lower
return.

3. The value of an asset, such as a share of stock, equals the present value of the cash flows the owner
of the share will receive, including the stream of dividends and the final sale price. If financial markets
process available information rationally, a stock price will equal the best estimate of the value of the
underlying business.

4. The financial system of an advanced economy is made up of many types of financial institutions,
such as the bond market, the stock market, banks, and investment funds. All these institutions act
to direct the resources of households who want to save some of their income into the hands of
households and firms who want to borrow.

5. National income accounting identities reveal some important relationships among

macroeconomic variables. In particular, for a closed economy, national saving must equal
investment. Financial institutions are the mechanism through which the economy matches
one person’s saving with another person’s investment.

6. The interest rate is determined by the supply of and demand for loanable funds. The supply of
loanable funds comes from households who want to save some of their income and lend it out.
The demand for loanable funds comes from households and firms who want to borrow for
investment. To analyze how any policy or event affects the interest rate, one must consider how
it affects the supply and demand for loanable funds.

7. National saving equals private saving plus public saving. A government budget deficit
represents negative public saving and, therefore, reduces national saving and the supply of
loanable funds available to finance investment. When a government budget deficit crowds
out investment, it reduces the growth of productivity and GDP.

CHAPTER OUTLINE:
I. Definition of financial system: the group of institutions in the economy that help to match
one person’s saving with another person’s investment.

II. Financial Institutions in the Economy

A. Financial Markets

1. Definition of financial markets: financial institutions through which

savers can directly provide funds to borrowers.

2. The Bond Market

a. Definition of bond: a certificate of indebtedness.

 b. A bond identifies the date of maturity and the rate of interest that will be
paid periodically until the loan matures.

c. One important characteristic that determines a bond’s value is its term.

i. The term is the length of time until the bond matures.

ii. Long-term bonds are riskier than short-term bonds because

holders of long-term bonds have to wait longer for repayment of
principal. To compensate for this risk, long-term bonds usually
pay higher interest rates than short-term bonds.

d. The second important characteristic of a bond is its credit risk.

i. This is the probability that the borrower will fail to pay

some of the interest or principal.

ii. When bond buyers perceive that the probability of default is

high, they demand a higher interest rate to compensate
them for this risk.

e. Government bonds

i. Some are considered a safe credit risk, such as those from

Germany, for example, and tend to pay low interest rates.

ii. UK government bonds have come to be referred to as gilt-

edged bonds, or more simply as gilts, reflecting that, in
terms of credit risk, they are ‘as good as gold’ (early bond
certificates had a gold edge – hence the term ‘gilt edged’).

iii. In contrast, junk bonds, pay very high interest rates; in

recent years some countries’ debt has been graded as ‘junk’.

f. There is an inverse relationship between the price and yield of a bond.

As a bond rises in price, the yield falls and vice versa.

3. The Stock Market

a. Definition of stock (or share or equity): a claim to partial

ownership in a firm.

b. The sale of stock to raise money is called equity finance; the sale of
bonds to raise money is called debt finance.

c. After a corporation issues stock by selling shares to the public, these

shares are sold on organized stock exchanges (such as the London Stock
Exchange and the Frankfurt Stock Exchange) and the prices of shares are
determined by supply and demand.

d. The price of a share generally reflects the perception of a company’s

future profitability.

e. A stock index is computed as an average of a group of stock prices.

B. Financial Intermediaries

1. Definition of financial intermediaries: financial institutions through

 which savers can indirectly provide funds to borrowers.

2. Banks
a. The primary role of banks is to take in deposits from people who want to
save and then lend them out to others who want to borrow.

b. Banks pay depositors interest on their deposits and charge borrowers a

higher rate of interest to cover their costs and earn profit.

c. Banks also play another important role in the economy by allowing

individuals to use checking deposits as a medium of exchange.

3. Investment or Mutual Funds

a. Definition of investment fund: an institution that sells shares to the public and
uses the proceeds to buy a portfolio of stocks and bonds.

b. The primary advantage of an investment fund is that it allows individuals

with small amounts of money to diversify.

c. Investment funds called “index funds” buy all of the stocks of a given stock
index. These funds have performed better than the average fund adopting
an active management approach. This may be because they trade stocks
less frequently and they do not have to pay the salaries of fund managers.

D. FYI: Key Terms in Stock Markets

1. Price

a. The previous close is the price of the last transaction that occurred before
the stock exchange closed in its previous day of trading.

2. Dividend

a. Corporations pay out some of their profits to their shareholders as dividend.

b. Profits not paid out are called retained earnings and are used by the
corporation for additional investment.

3. Price-earnings ratio

a. A corporation’s earnings, or accounting profit, is the amount of revenue it

receives for the sale of its products minus its costs of production as measured
by its accountants

b. Earnings per share is the company’s total earnings divided by the number of
shares of stock outstanding.

c. The price-earnings ratio or P/E, is the price of a corporation’s stock divided by

the amount the corporation earned per share over the past year.

d. A higher P/E indicates that a corporation’s stock is expensive relative to its

recent earnings. This might indicate either that people expect earnings to rise
in the future or that the stock is overvalued.

E. Other Financial Instruments

1. Collateralized Debt Obligations (CDOs)

 a. CDOs are pools of asset-backed securities which are dependent on the
value of the asset that backs them up and the stream of income that flows
from these assets.

b. In setting up a CDO, a manager encourages investors to buy bonds, the

funds of which are used to buy pools of debt – mortgage debt. The reward
or stream of income being the interest paid on the mortgages.

c. This debt is split and rated according to its risk into tranches; low-risk
tranches attract low interest rates whilst the riskier tranches attract higher
interest rates.

d. The market for these debts became complex and moved from the prime
market of safe lending and low risk into the sub-prime market, lending
to individuals with high credit risks.

e. Investors in these higher risk tranches can seek ratification of the risk they
are under -taking by referring to ratings agencies which examine and report
on the inherent risk of the investment.

2. Definition of credit default swaps (CDS): a means by which a

bondholder can insure against the risk of default.

a. The financial crisis of 2007–09 brought to light new financial instruments

traded in the financial system that may not have been familiar to many
ordinary people; indeed, there were some senior bankers who were
accused of not fully understanding what they were trading!

b. An example.

i. A bank buys a bond in an asset-backed for €5 million.

ii. The coupon payment (the interest on the bond) is 10 per cent.

iii. The bond is backed by the stream of cash flows being paid by
mortgage holders. To earn the coupon payment the mortgage
holders must meet their obligations with mortgage payments.

iv. The bank wishes to secure the risk of mortgage defaulting so

agrees a fee to take out a policy on the risk. It becomes a
protection buyer

v. The effect is for the bank to swap the risk with the insurer (which
could also be another bank or a hedge fund) which becomes the
protection payer.

vi. Things can get complicated because the insurer may itself take
out a hedge against the risk.

c. Some bonds are backed by a pool or mortgage debts and the risk is
that the mortgage payer defaults on the payment in some way.

d. In the event of the bond defaulting then the protection seller pays out to
the protection buyer.

e. CDS represent sound business principles when the risk of default is very low,
which was the case when they were first developed in the late 1990s and
when the bonds being insured were corporate bonds with a low risk attached
to them.
 f. The trouble came with the collapse in the housing market from around 2007.

F. Summary

1. There are many financial institutions in an advanced economy.

2. These institutions all serve the same goal—moving funds from savers to
borrowers.
III. Present Value: Measuring the Time Value of Money

A. Money today is more valuable than the same amount of money in the future.

B. Definition of present value: the amount of money today that would be needed to
produce, using prevailing interest rates, a given future amount of money.

1. Example: you put €100 in a bank account today. How much will it be worth in N
years?

2. Definition of future value: the amount of money in the future that an amount
of money today will yield, given prevailing interest rates.

a. Definition of compounding: the accumulation of a sum of money in, say, a

bank account where the interest earned remains in the account to earn
additional interest in the future.

b. If we invest €100 at an interest rate of 5 percent for 10 years, the future

value will be (1.05)10 ´ €100 = €163.

c. Example: you expect to receive €200 in N years. What is the present

value of €200 that will be paid in N years?

i. To compute a present value from a future value, we divide by

the factor (1 + r)N.

ii. If the interest rate is 5 percent and the €200 will be received 10
years from now, the present value is €200/(1.05)10 = €123.

If r is the interest rate then an amount €X to be received in N

years has a present value of €X / (1 + r)N

d. The higher the interest rate, the more you can earn by depositing your
money at the bank, so the more attractive having €100 today becomes.

C. Applying the Concept of Net Present Value

1. The concept of present value also helps to explain why investment is inversely
related to the interest rate. The quantity of loanable funds demanded declines
when the interest rate rises.

2. The decision will also have to take account of many other factors such as risk,
changing interest rates and inflation and is thus far more complex but the use
of present value aids decision making.

IV. Managing Risk

A. Risk Aversion

1. Most people are risk averse.

a. Definition of risk averse: exhibiting a dislike of uncertainty

b. People dislike bad things happening to them.

 c. In fact, they dislike bad things more than they like comparable good
things.

d. For a risk-averse person, the pain from losing the €1,000 would exceed
the gain from winning €1,000.

2. Economists have developed models of risk aversion using the concept of utility,
which is a person’s subjective measure of well-being or satisfaction.

a. A utility function exhibits the property of diminishing marginal utility: the

more wealth a person has, the less utility he gets from an additional euro.

b. Because of diminishing marginal utility, the utility lost from losing €1,000 is
greater than the utility of winning €1,000.

c. As a result, people are risk averse.

B. The Markets for Insurance

1. One way to deal with risk is to purchase insurance.

2. From the standpoint of the economy as a whole, the role of insurance is not to
eliminate the risks inherent in life but to spread them around more efficiently.

a. Having insurance does not prevent bad things from happening to you.

b. However, the risk is shared among thousands of insurance company

shareholders rather than being borne by you alone.

3. The markets for insurance suffer from two types of problems that impede their
ability to spread risk.

a. A high-risk person is more likely to apply for insurance than a low-risk

person. This is adverse selection.

b. After people buy insurance, they have less incentive to be careful about
their risky behaviour. This is moral hazard.
C. Pricing Risk

1. Mortgage backed bonds.

a. If an issuer of bonds is sound then risk of default maybe close to zero.

b. If the issuer is weak then the risk of default is closer to 1.

c. As a debt is pooled the outcomes become more varied.

d. If an asset is deemed very risky, the expected returns will need to be

higher and vice versa.

2. Issuing life assurance involves a risk

a. The job of the actuary is to provide information to the insurer on the

chances of death occurring under different situations.

b. Models can incorporate historical data to help determine risk in the

future.

D. Diversification of Idiosyncratic Risk

1. Practical advice that finance offers to risk adverse people: “Don’t put all your eggs
in one basket.”

2. Definition of diversification: the reduction of risk achieved by replacing a single

risk with a large number of smaller unrelated risks.

a. A person who buys stock in a company is placing a bet on the future

profitability of that company.

b. Risk can be reduced by placing a large number of small bets, rather than
a small number of large ones.

3. Risk can be measured by the standard deviation of a portfolio’s return.

a. Standard deviation measures the volatility of a variable.

b. The higher the standard deviation of a portfolio’s return, the riskier it is.

c. The risk of a stock portfolio falls as the number of stocks increases.

4. It is impossible to eliminate all risk by increasing the number of stocks in the

portfolio.

a. Definition of idiosyncratic risk: risk that affects only a single

economic actor.

b. Definition of aggregate risk: risk that affects all economic actors at

once.

c. Diversification can eliminate idiosyncratic risk, but will not affect

 aggregate risk.

E. The Trade-off between Risk and Return

1. People face trade-offs.

2. Risk adverse people are willing to accept the risk inherent in holding
stock because they are compensated for doing so.

3. When deciding how to allocate their savings, people have to decide how much
risk they are willing to undertake to earn a higher return.

4. The choice of a particular combination of risk and return depends on a person’s

risk aversion, which reflects a person’s own preferences.

V. Asset Valuation

A. The price of a share of stock is determined by supply and demand. To understand stock
prices, we need to understand what determines a person’s willingness to pay for a share
of stock.

B. Fundamental Analysis

1. Definition of fundamental analysis: the study of a company’s accounting

statements and future prospects to determine its value.

2. If the price of a share of stock is less than the value, the stock is said to be
undervalued.

3. If the price of a share of stock is greater than its value, the stock is said to be
overvalued.

4. If the price of a share of stock is equal to its value, the stock is said to be fairly
valued.

5. The value of a stock to a shareholder is what he receives from owning it, which
includes the present value of dividend payments and the final sale price.

a. Both of these are highly related to the firm’s ability to earn profits.

b. The firm’s profitability depends on a large number of factors that affect

the demand for its product and its costs of doing business.

6. There are three ways to rely on fundamental analysis to select a stock portfolio.

a. Do all of the necessary research yourself.

b. Rely on the advice of Wall Street analysts.

VI. Saving and Investment in the National Income Accounts

A. Some Important Identities

1. Remember that GDP can be divided up into four components: consumption,

 investment, government purchases, and net exports.

Y = C + I + G + NX

2. We will assume that we are dealing with a closed economy (an economy that
does not engage in international trade or international borrowing and lending).
This implies that GDP can now be divided into only three components:

Y=C+I+G

3. To isolate investment, we can subtract C and G from both sides:

Y-C-G=
4. The left-hand side of this equation (Y – C – G) is the total income in the
I
economy after paying for consumption and government purchases. This
amount is called national saving.

5. Definition of national saving (saving): the total income in the economy

t at remains after paying for consumption and government purchases.
h

6. Substituting saving (S) into our identity gives us:

S=I
7. This equation tells us that saving equals investment.

8. Let’s go back to our definition of national saving once again:

S=Y-C-G

9. We can add taxes (T) and subtract taxes (T):

S = (Y - C - T) + (T - G)
 10. The first part of this equation (Y – T – C) is called private saving; the second
part (T – G) is called public saving.

a. Private saving is the income that households have left after

paying for taxes and consumption.

b. Public saving is the tax revenue that the government has left
after paying for its spending.

c. Budget surplus where government tax revenue is greater than

spending because receives more money than it spends.

d. Budget deficit where government tax revenue is less than

spending and the government has to borrow to finance spending.

11. The fact that S = I means that for the economy as a whole saving must be
equal to investment.

a. The bond market, the stock market, banks, investment funds, and
other financial markets and institutions stand between the two sides
of the S = I equation.

b. These markets and institutions take in the nation's saving and direct
it to the nation's investment.

B. Case study: Debt and Deficit

1. It is important to distinguish between government debt and a

government deficit.

2. A government deficit refers to a situation where a government

spends more than it generates in tax revenue over a period and has to
borrow to fund spending.

a. For example, if the UK government budgets to spend £750

billion in 2019-20 but only generates £700 billion in tax and
other revenue, it will need to borrow £50 billion.

b. The government’s deficit for the year is £50 billion.

3. This sum of money becomes part of the national debt which is the
accumulation of the total debt the government owes.

4. Both the debt and the deficit can be expressed as a percentage of

GDP.

a. For example, the UK government deficit in the financial year

ending March 2018 was £40.7 billion representing 2 per cent
of GDP. This had fallen from £93.5 bn in 2015.

b. The national debt, however, was reported at £1.76 trillion or

85.8 per cent of GDP.
 c. Whilst the deficit had shrunk the national debt rose.

C. The Meaning of Saving and Investment

1. In macroeconomics, investment refers to the purchase of new capital,

such as equipment or buildings.

2. If a person spends less than they earn and uses the rest either put in a
bank, or to buy stocks or investment funds, economists call this saving.

VII. The Market for Loanable Funds

A. Definition of market for loanable funds: the market in which those who want to
save supply funds and those who want to borrow to invest demand funds.

B. Supply and Demand for Loanable Funds

1. The supply of loanable funds comes from those who spend less than they
earn.

a. The supply can occur directly through the purchase of some stock
or bonds or indirectly through a financial intermediary.

2. The demand for loans comes from households and firms who wish to
borrow funds to make investments.

a. Families generally invest in new homes while firms may borrow to

purchase new equipment or to build factories.

3. The price of a loan is the interest rate.

a. The interest rate represents the amount that borrowers pay for
loans and the amount that lenders receive on their saving.

b. A high interest rate makes borrowing more expensive, the

quantity of loanable funds demanded falls as the interest rate
rises.

i. All other things being equal, as the interest rate rises,

the quantity of loanable funds demanded will fall.
c. A high interest rate makes saving more attractive, the quantity
of loanable funds supplied rises as the interest rate rises.
i. Funds supplied will increase.
4. At equilibrium, the quantity of funds demanded is equal to the quantity of
funds supplied.

a. Shifts in the demand and supply of the loanable funds bring about
changes to the interest rate.

b. If the interest rate in the market is greater than the equilibrium rate, the
quantity of funds demanded would be smaller than the quantity of funds
 supplied. Lenders would compete for borrowers, driving the interest
rate down.

c. If the interest rate in the market is less than the equilibrium rate, the
quantity of funds demanded would be greater than the quantity of funds
supplied. The shortage of loanable funds would encourage lenders to
raise the interest rate they charge.

5. The supply and demand for loanable funds depends on the real (rather than
nominal) interest rate because the real rate reflects the true return to saving and
the true cost of borrowing.

C. Policy 1: Saving Incentives

1. Suppose that the government changes the taxation system to encourage greater
saving.

a. This will cause an increase in saving, shifting the supply of loanable

funds to the right.

b. The equilibrium interest rate will fall and the equilibrium quantity of
funds will rise.

2. Thus, the result of the new tax arrangements would be a decrease in the
equilibrium interest rate and greater saving and investment.

3. The interest elasticity of demand and supply measures the

responsiveness of the demand and supply of loanable funds to changes
in the interest rate.

E. Policy 2: Investment Incentives

1. Suppose instead that the government passed a new law lowering taxes for any
firm building a new factory or buying a new piece of equipment (through the use
of an investment tax credit).

a. This will cause an increase in investment, causing the demand for

loanable funds to shift to the right.

b. The equilibrium interest rate will rise, and the equilibrium quantity of
funds will increase as well.

2. Thus, the result of the new tax laws would be an increase in the equilibrium
interest rate and greater saving and investment.

F. Policy 3: Government Budget Deficits and Surpluses

1. A budget deficit occurs if the government spends more than it receives in tax
revenue.

2. This implies that public saving (T – G) falls, which will lower national saving.
 a. The supply of loanable funds will shift to the left.

b. The equilibrium interest rate will rise, and the equilibrium quantity of
funds will decrease.

3. When the interest rate rises, the quantity of funds demanded for investment
purposes falls.

4. Definition of crowding out: a decrease in investment that results from

government borrowing.

5. When the government reduces national saving by running a budget deficit, the
interest rate rises and investment falls.

6. Government budget surpluses work in the opposite way. The supply of loanable
funds increases, the equilibrium interest rate falls, and investment rises.

G. Intertemporal Choice

1. Financial markets, unlike most other markets, serve the important role of
linking the present and the future.

2. A decision to save is a postponement of consumption in the present to

consumption at some point in the future.

3. The intertemporal substitution effect is the rate at which economic actors

respond to changes in the interest rate by changing consumption and savings
decisions.

VIII. Conclusion

A. ‘Neither a borrower nor a lender be,’ Polonius advises his son in Shakespeare’s Hamlet. If
everyone followed this advice, this chapter would have been unnecessary. Few
economists would agree with Polonius. In our economy, people borrow and lend often,
and usually for good reason. The financial system has the job of coordinating all this
borrowing and lending activity.

B. In many ways, financial markets are like other markets in the economy. The price of
loanable funds – the interest rate – is governed by the forces of supply and demand, just
as other prices in the economy are.

C. In one way, however, financial markets are special. Financial markets, unlike most other
markets, serve the important role of linking the present and the future.

1. For example a decision to save is a postponement of consumption in the present

to consumption at some point in the future. The time element in these decisions
is referred to as intertemporal choice.

2. Intertemporal substitution effect is the response of economic actors to

changes in the interest rate by changing consumption and savings decisions.

IX. In the News: Budget Deficits

A. Italy is one country where the debt burden is putting pressure on its financial system.