28-Feb-22

TOPIC 4: Saving, Investment,

and the Financial System
• What are the main types of financial
institutions in the economy, and what is their
function?
• What are the three kinds of saving?
• What’s the difference between saving and
investment?
• How does the financial system coordinate
saving and investment?
• How do government policies affect saving,
investment, and the interest rate?
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Financial Institutions
• Financial system
– Group of institutions in the economy that
help match the saving of one person with
the investment of another
• Financial institutions
– Institutions through which savers can
directly provide funds to borrowers
– Financial markets
– Financial intermediaries
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Financial Markets
• Financial markets
– Savers can directly provide funds to
borrowers
– The bond market (debt finance):
• A bond is a certificate of indebtedness
– The stock market (equity finance):
• A stock is a claim to partial ownership in a
firm

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Bond and Stock

• The sale of stock to raise money is called equity
finance, whereas the sale of bonds is called debt
finance.
• The owner of the share of company is a part owner
of company, while the owner of bond is a creditor
of corporation.
• If a company is profitable, the stock holder enjoy
benefits of these profits, whereas the bondholders
get only the interest on their bond.
• Compared to the bond, stocks offers the holder
both higher risk and potentially higher return.
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Financial Intermediaries
• Financial intermediaries
– Institutions through which savers can
indirectly provide funds to borrowers
– Banks
– Mutual funds: institutions that sell shares
to the public and use the proceeds to buy
portfolios of stocks and bonds

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Accounting Identities
• Gross domestic product (GDP, Y)
– Total income = Total expenditure
Y = C + I + G + NX
• Y = gross domestic product, GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports

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Consumption, C
• def: Disposable income is total income minus
total taxes: Y – T.
• Consumption function: C = C (Y – T )
Shows that (Y – T )  C
• def: Marginal propensity to consume (MPC)
is the change in C when disposable income
increases by one dollar.

The consumption function

C

C (Y –T )

The slope of the

MPC
consumption function
1 is the MPC.

Y–T

Investment, I
• The investment function is I = I (r )
where r denotes the real interest rate,
the nominal interest rate corrected for inflation.
• The real interest rate is
– the cost of borrowing
– the opportunity cost of using one’s
own funds to finance investment
spending
So, r  I

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The investment function

r
Spending on
investment goods
depends negatively on
the real interest rate.

I (r )

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Government spending, G
• G = govt spending on goods and
services
• G excludes transfer payments
(e.g., Social Security benefits,
unemployment insurance benefits)
• Assume government spending and total
taxes are exogenous:
G =G and T =T

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Accounting Identities
– For T = taxes minus transfer payments
S = Y – C – G can be rewritten as:
S = (Y – T – C) + (T – G)
• Private saving, Y – T – C
– Income that households have left after
paying for taxes and consumption
• Public saving, T – G
– Tax revenue that the government has left
after paying for its spending
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Accounting Identities
• Assume closed economy: NX = 0
• Y = C + I + G, so I = Y – C - G
• National saving (saving), S
• Total income in the economy that remains
after paying for consumption and
government purchases
• By definition: S = Y – C – G
• It follows: Saving (S) = Investment (I)
for a closed economy
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Closed and Open Economy

• For a closed economy, investment equals
saving: 𝐒 = 𝐈
• For an open economy, a difference
between investment and saving is trade
balance: 𝐒 − 𝐈 = 𝐍𝐗

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Accounting Identities
• Budget surplus: T – G > 0
– Excess of tax revenue over government
spending = public saving (T-G)
• Budget deficit: T – G < 0
– Shortfall of tax revenue from government
spending = – (public saving) = G – T

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Active Learning 1 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, net taxes, private saving,
national saving, and investment.

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Active Learning 1 A. Answers

Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
(all in trillions)
• Public saving = T – G = – 0.3
• Net taxes: T = G – 0.3 = 1.7
• Private saving = Y–T–C = 10 – 1.7 – 6.5 = 1.8
• National saving S=Y–C–G = 10 – 6.5 – 2 = 1.5
• Investment = national saving = 1.5

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Active Learning 1 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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Active Learning 1 B. Answers

In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged, so investment
is unchanged.
2. If consumers save $50 billion and spend
$150 billion, then national saving and
investment each fall by $150 billion.

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Active Learning 1 C. Discussion questions

The two scenarios from this exercise were:
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.
• Which of these two scenarios do you think is
more realistic?
• Why is this question important?

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The Meaning of Saving and Investment

• Private saving
– Income remaining after households pay
their taxes and pay for consumption.
– Examples of what households do with
saving:
• Buy corporate bonds or equities
• Purchase a certificate of deposit at the bank
• Buy shares of a mutual fund
• Let accumulate in saving or checking
accounts
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The Meaning of Saving and Investment

• Investment
– Is the purchase of new capital
– Examples of investment:
• General Motors spends $250 million to build
a new factory in Flint, Michigan.
• You buy $5000 worth of computer equipment
for your business.
• Your parents spend $300,000 to have a new
house built.
Investment is NOT the purchase of stocks and bonds!
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The Market for Loanable Funds

• Loanable funds market
– A supply–demand model of the financial
system
– Helps us understand:
• How the financial system coordinates
saving & investment.
• How government policies and other factors
affect saving, investment, the interest rate.

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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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The Market for Loanable Funds

• The supply of loanable funds comes from
saving:
– Households with extra income can loan it
out and earn interest.
– Public saving
• If positive, adds to national saving and the
supply of loanable funds.
• If negative, it reduces national saving and the
supply of loanable funds.

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The Slope of the Supply Curve

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

60 80 Loanable Funds
($billions)
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The Market 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.

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The Slope of the Demand Curve

A fall in the interest

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

Demand

50 80 Loanable Funds
($billions)
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Equilibrium
The interest rate adjusts
to equate supply and
Interest Supply
demand.
Rate
The equilibrium quantity
of loanable funds equals
5% equilibrium investment
and equilibrium saving.

Demand

60 Loanable Funds
($billions)
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Policy Effects
• Saving Incentives
– Tax Incentives on Saving: Reduce tax on
saving creates motivation for saving.
• Investment Incentives
– Any policy encourages investment (e.g.
reduce tax on investment…)

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Policy 1: Saving Incentives

• Saving Incentives: Tax Incentives on
Saving: Reduce tax on saving creates
motivation for saving.
– Supply curve shifts to the right;
– Equilibrium interest rate decreases;
– Saving increases.

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Policy 1: Saving Incentives

Tax incentives for
saving increase the
Interest supply of loanable
Rate S1 S2 funds
…which reduces the
equilibrium interest
5% rate
4% and increases the
equilibrium quantity of
D1 loanable funds

60 70 Loanable Funds
($billions)
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Policy 2: Investment Incentives

• Investment Incentives
– Any policy encourages investment (e.g.
reduce tax on investment…)
• Effects:
– The demand curve shifts to the right
– Interest rate increases
– Saving Increases

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Policy 2: Investment Incentives

An investment tax
credit increases the
Interest demand for loanable
Rate S1 funds
…which raises the
6%
equilibrium interest
5% rate
and increases the
D2 equilibrium quantity
D1 of loanable funds

60 70 Loanable Funds
($billions)
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Active Learning 2 Budget deficits

Use the loanable funds model to analyze
the effects of a government budget deficit
(spending is larger than revenue)
• Draw the diagram showing the initial equilibrium.
• Determine which curve shifts when the
government runs a budget deficit.
• Draw the new curve on your diagram.
• What happens to the equilibrium values of the
interest rate and investment?

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Active Learning 2 Answers

Interest A budget deficit
Rate
reduces national
S2
S1 saving and the
supply of loanable
funds
6%
…which increases
5%
the equilibrium
interest rate
and decreases the
D1
equilibrium quantity
of loanable funds
50 60 Loanable Funds
($billions) and investment.

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Budget Deficits, Crowding Out,

and Long-Run Growth
• Our analysis:
– Increase in budget deficit causes fall in investment
– The government borrows to finance its deficit,
leaving less funds available for investment:
crowding out
• Borrowing to finance deficit crowds out borrowing for
private investment.
• 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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The special role of r

r adjusts to equilibrate the goods market and the

loanable funds market simultaneously:
If L.F. market in equilibrium, then
Y–C–G =I
Add (C +G ) to both sides to get
Y = C + I + G (goods market eq’m)
Thus,

Eq’m in L.F.
market  Eq’m in goods
market

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Summary
• National saving equals private saving plus
public saving.
• In a closed economy, national saving equals investment.
The financial system makes this happen.
• The supply of loanable funds comes from saving. The
demand for funds comes from investment. The interest rate
adjusts to balance supply and demand in the loanable funds
market.
• A government budget deficit is negative public saving, so it
reduces national saving, the supply of funds available to
finance investment.
• When a budget deficit crowds out investment,
it reduces the growth of productivity and GDP.
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