Chapter 7: Savings and Investment

Objectives
• Determinants of saving, investment, and interest rates
• Effect of government budget deficits
• Effect of international borrowing and lending
 Physical Capital vs. Financial Capital

 Physical capital
• Tools, instruments, machines, buildings, and other
items that have been produced in the past and that
are used today to produce goods and services.

 Financial capital
• The funds that firms use to buy physical capital.
 Capital and Investment

 Capital Stock (K)

• Total amount of capital measured at a given point in
time.
 Gross investment (I)
• total amount spent on purchases of new capital and on
replacing depreciated capital.
 Depreciation (capital consumption allowance)
• decrease in the quantity of capital that results from wear
and tear and obsolescence.
 Net investment (IN)
• change in the quantity of capital.
• I - CCA
K(t) = K(t-1) + IN
 Wealth and Saving

 Wealth (W)
• the value of all the things that people own.
 Saving (S)
• the amount of income that is not paid in taxes or
spent on consumption goods and services.
 Wealth increases with
• Saving (S)
• Capital gains (CG)
 Wealth is decreased by capital losses or dissaving.
 W(t) = W(t-1)+S(t-1)+ CG(t-1)
Markets for financial capital

 Saving is the source of funds used to finance

investment.

 These funds are supplied and demanded in three

types of financial markets:
• Loan markets
• Bond markets
• Stock markets
 Financial Institutions and markets

Financial institution

•a firm that that operates on both sides of the markets for financial
capital.
•borrower in one market and a lender in another.

Types of financial institutions (more on this later)

• Investment banks
• Commercial banks
• Government-sponsored mortgage lenders
• Pension funds
• Insurance companies
The Market for Loanable Funds

 The market for loanable funds

• the market in which households, firms,
governments, and financial institutions borrow and
lend.
• The market influences
– Saving and investment
– Interest rates
 The Market for Loanable Funds

The market for loanable funds is the aggregate of all the

individual financial markets.
Funds that Finance Investment
1. Household saving S
2. Government budget surplus (T -Tr – G)
3. Loans from the rest of the world (M – X)
Because Income Side of GDP = Expenditure Side of GDP
C + S + (T-Tr) = C + I + G + (X-M)
 I = S + (T-Tr)-G + (M-X)
 The Market for Loanable Funds

 Nominal interest rate

• More specific name for “interest rate”
• Not adjusted for effects of inflation
• ($ of interest / $ of principal) per period of time
 Real interest rate
• nominal interest rate adjusted to remove the effects
of inflation on the purchasing power of money.
• nominal interest rate minus the inflation rate.
 The Market for Loanable Funds

Demand for loanable funds

 the relationship between the quantity of loanable funds

demanded and the real interest rate, ceteris paribus.

 Business investment is the main item that makes up

the demand for loanable funds.
 The Market for Loanable Funds

Changes in the Demand for Loanable Funds

(a shift in the demand curve)
 When expected profits rises, the demand for loanable
funds rises

 Tax policy can affect demand for loanable funds

• Investment tax credit
• Accelerated depreciation.
 The Market for Loanable Funds

 The Supply of Loanable Funds

• the relationship between the quantity of loanable
funds supplied and the real interest rate, ceteris
paribus.

• Saving is the main item that makes up the supply

of loanable funds.
Supply of Loanable Funds
 The Market for Loanable Funds

 Changes in the supply of loanable funds

• Temporary changes in disposable income

• Expected future income
• Wealth
• Perceived default risk of borrowers
The Market for Loanable Funds: Equilibrium
 The Market for Loanable Funds

• Assuming no government or international sector,

• SLF= Saving
• DLF=Investment

• Analyze effects of each of the following on Saving,

Investment, real interest rate.
• A technological advance that creates profitable
investment opportunities.
• Households become more optimistic about future
income growth.
• Government creates more tax incentives for business
investment.
 Government in the Market for Loanable Funds

Government enters the loan market when it has a budget

surplus or deficit.
• A government budget surplus increases the supply of
funds
• A government budget deficit increases the demand for
funds.
Includes federal, state and local governments.
Government Surplus in the Market for Loanable Funds
Government Deficit in the Market for Loanable Funds
An increase in the government budget deficit will lead
to ____ interest rates and ____ private investment

1. Higher; less
2. Higher; more
3. Lower; less
4. Lower; more

0% 0% 0% 0%
ss

ss

e
e

or
or
le

le
10

;m
m
;

;
er

er
;

er
er

w
gh

w
Lo
gh
Hi

Lo
Hi

Countdown
Government in the Market for Loanable Funds:
Ricardo-Barro Effect
 The Global Loanable Funds Market

• The loanable funds market is global, not national.

• Financial capital is mobile: It moves to the best
advantage of lenders and borrowers.
• Because lenders are free to seek the highest real
interest rate and borrowers are free to seek the lowest
real interest rate, the loanable funds market is a single,
integrated, global market.
• Funds flow into the country in which the real interest rate
is highest and out of the country in which the real interest
rate is lowest.
The Global Loanable Funds Market

International Borrowing and Lending

 If a country’s net exports are negative,
• Country is a net borrower
• quantity of loanable funds in that country is greater
than national saving.
 If a country’s net exports are positive,
• the country is a net lender
• the quantity of loanable funds in that country is less
than national saving.
 Foreign Holdings of U.S. Government Bonds
(Billions of $)
Total Foreign Holdings = $4,347 b.

900
800 China, Mainland
Japan
700 United Kingdom
600 Oil Exporters
Brazil
500 Carib Bnkng Ctrs
400 Hong Kong
Canada
300 Taiwan
200 Russia
Switzerland
100 All Other
0
11/1/2010
The Global Loanable Funds Market

X-M<0 X-M>0
(e.g. U.S. today) (e.g. China today)