INTRODUCTION TO

MACROECONOMICS

TOPIC 4: SAVINGS, INVESTMENTS

AND THE FINANCIAL SYSTEM
Study plan
• The financial system.
• Saving and investment’s accounting identity
• Loanable funds market and the role of the government

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How to promote economic growth
• Promote savings → Investment for future consumption?
• A simplified example: An economy can produce 100 tons of steel per year.
There are two options:
• Spend 90 tons to make cars, motorbike, appliances…, and only 10 tons
to make new machines, or new facilities.
• Spend 60 tons to make consumption goods, and devote 40 tons to
produce capital goods.
• Which case that have a higher saving rate?
Physical investment and monetary
funds
• Our economy is fully monetarized. Firms and consumers need to
spend money to obtain goods and services.
• Savings and investment on the physical level happens from the
flows of money across the economy.
• For example: 10 tons of steel as investment means that one needs to
expends a $10,000 (=10 tons x $1,000) flow of money for the
investment purpose.
• How can it happen in our economy?
Circular flow diagram
Saving and investment in the whole
economy
• Remember: Y = C + I + G + NX?
• We can divide its total output (Y) for two purposes:
• Instant consumption (C).
• Investments to sustain current and increase future
consumption (I).

6
The Financial System
 Financial cycle of a person
• Start work at early or mid 20s and may need to borrow to buy houses or
big items (cars…).
• Accumulate financial funds until retirement → Households’ savings.
• After retirement, withdrawn from financial savings to cover living cost.
The level
of wealth

Peak wealth at 40s and 50s

No money at early 20s Retirement Age

Firms and long-term investments
• Where do firms get the funds to invest from?
Profits re-investment

From households’ savings

• How are funds transferred from households to firms?

Directly – Financial market

Households’ savings
to firms’ investments
Indirectly – Financial intermediaries

9
Big-size investments of an economy
• Steel plants typically last about 40 years, and require reinvestment
after 20–25 years. Ex: Hoa Phat’s steel plant in Quang Ngai needs a
fund of ~$3.34 billion USD.
• Thermal power plants are planned to work for at least 40 years. In
Vietnam, these plants needs $1-2 billion USD of investments.
• Nghi Son Oil Refinery cost $9 billion USD.
• Vietnam's Ninh Thuan nuclear power project is projected to need
investment of at least $22 billion USD.
The financial system
• The financial system helps to transfer funds from savers to
borrowers.
• Who want to save:
• Workers accumulate funds for the retirement plan and future spendings
(kids’ tuition fee, healthcare expenditure…).
• Wealthy people have big assets and want to generate returns from their
assets.
• Governments possess sovereign wealth funds (e.g. Norway’s fund with
US$1.62 trillion in asset).
• Firms have unspent funds.
The financial system (2)
• Who want to borrow:
• Firms to fund their businesses’ investments.
• Houses, apartments, and big items’ buyers.
• Consumers for their consumption spending (e.g. borrow from credit
cards).
• The governments for their deficits.
• Financial investors for their trading.
The financial system (3)
• Financial institutions
• Financial markets. E.g. stock exchange, bond market.
• Financial intermediaries. E.g. commercial banks, insurance companies.

• Rules and norms on the financial market.

• Formal regulations and laws from the government.
• Implicit rules between actors in financial market. E.g.: “chơi hụi”,
borrowings between family members or friends.
Financial institutions includes
• Financial markets (direct channels):
• Bond market.
• Stock market.
• Financial intermediaries (indirect channels):
• Banks.
• Insurance companies.

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 The Bond Market
• Bonds are investments where an
investor lends money to a company
or a government for a set period of
time, in exchange for:
• Regular interest payments,
• Payment of the principal at the
date of maturity.

15
 Examples of bonds
Vietnam government issues a 5-year 1-billlion VND bond on 1/1/2022, the annual interest rate is
7%. The payment structure is:
• At the end of each of the year 2022 – 2026: VN government pays 70 million VND as the interest
payment.
• At the day of maturity (31/12/2026): repay 1 billion VND of the principal to investors.

On May 2022, VinGroup issued a total of 525 million USD at 3% interest rate to international
market. The maturity date is on May 10, 2027. For each piece of 1 million USD, investors will
receive:
• Interest (coupon) payment every year?
• The principal payment?
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Factors in the bond market
• The bond term: length of time until maturity (payment of the principal):
• Short term: a few days to a few months
• Long term: one year to 30 years.

• Corporate vs government (central or local/municipal) bonds: the bonds issued

by the government or the private sectors.
• Determinants of bond’s interest rate:
• Credit risk: higher probability of default → higher interest rates.
• Term risk: Longer term → higher interest rates.
• Corporate bonds is typically considered riskier than government bonds. E.g. Vingroup
needs to pay 15% of interest for its recent 2023 issue of VND-denominated bond. The U.S.
government bond (US Treasury bond) are considered to be among the safest in the world.
Infos
• https://cbonds.hnx.vn/to-chuc-phat-hanh/danh-sach-trai-phieu
• https://cafef.vn/ai-dang-lam-mua-lam-gio-tren-thi-truong-trai-
phieu-doanh-nghiep-20200819073655403.chn#img-lightbox-1
The stock market
• A stock is a certificate that represents a claim to partial ownership in a
firm, and hence a share of the profits that the firm produces.
• Example: if a newly established corporation issues 1,000,000 shares of
stock, then each share represents a claim to 1/1,000,000 of the firm.
• Firms usually pay parts of its profits to stockholders as dividends.
• Example: in 2023, Vinamilk pay 14% cash dividend. It is 1,400VND per
share (the book value at 10,000VND).

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Public company and the stock exchange
• A public company is a company whose ownership is organized via
shares of stock which are intended to be freely traded on a stock
exchange.
• Examples:
• Vietnam’s stock exchange: Ho Chi Minh Stock Exchange (HOSE) or Hanoi Stock
Exchange (HNX).
• Vietnam public companies: Vinamilk, Vietcombank, Hoa Phat Group, …

• Stock index: average of a group of stock prices (e.g. VN-Index, VN30).

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Major Stock Exchanges
• New York Stock Exchange.
• Nasdaq (US).
• London Stock Exchange.
• Tokyo Stock Exchange.
• Shanghai Stock Exchange.
….
Financial Intermediaries
• Financial intermediaries are financial institutions through which
savers (lenders) can indirectly lend funds to borrowers.
• Types of financial intermediaries:
• Commercial banks.
• Insurance companies.
• Mutual/pension funds.
• Credit unions.

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Commercial banks
• The role of commercial banks:
• Accept deposits from savers.
• Make loans to borrowers.
• Credit quality control and mismatch management.
• Financial services.
• Example:
• A customer deposits 100 mil VND at 6% interest rate at Vietcombank. The term is one
year.
• Vietcombank lends money to a company at 8% a year. The discrepancy between the
deposit rate and the lending rate is Vietcombank’s profit.
• Vietcombank takes the risk of bankruptcy for its depositors.
• Vietcombank’s deposit rates for
individual customers.
• Obtained on Feb 25th on its
website:
https://www.vietcombank.com.
vn/en/Personal/Cong-cu-Tien-
ich/KHCN---Lai-suat
• NIM (Net Interest Margin): the difference between earning in interest on
loans compared to the amount it is paying in interest on deposits.
• The higher NIM, the more profitable the bank is.

Source: https://vietstock.vn/2023/11/nim-quy-3-tat-ca-ngan-hang-
deu-sut-giam-dieu-gi-dang-dien-ra-757-1122414.htm
Insurance Companies
• Insurance companies are financial intermediaries which offer direct insurance or
reinsurance services, providing financial protection from possible hazards in
the future.
• Investors make regular payments (premium) to the insurance companies (the
insurers). Insurance companies invest the customers’ money to a portfolio in the
financial market.
• Insurance buyers can withdraw the accumulated premium (depending on the
policy).
• In the case of hazards (serious health problem or death or disasters), the
insurance company pay an agreed (usually large) amount of money to the
customers.
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Credit unions
• Similar functions to commercial banks; but it is member-owned
and non-profit.
• In the case of Vietnam, “hụi” or “quỹ tín dụng nhân dân” can
be considered equivalent to credit unions.
Mutual funds
• They are institutions that sells shares to the public and use these
money to buy a portfolio of stocks and bonds.
• Their advantages: diversification from market risk (e.g. individual
investments from one or two companies) and professional services
from experts.
• Popular in the US.
• Example in Vietnam: Vietnam Equity (UCITS) Fund of Dragon
Capital.
 The fund’s vs VN-Index’s returns on investment.
Manage fee: 2-5%

Source: obtain on Vietnam Equity (UCITS) Fund (VEF)’s website on March 18th 2024.
National Income Accounting
What is an accounting identity?
• In accounting, finance and economics, an accounting identity is an
equality that must be true regardless of the value of its variables, or
a statement being true by definition or by construction.
• Example: Within a period of time, without changing in net saving,
any person must record:
Total amount of outflow of money = Total amount of inflow of money

• Accounting identity helps to clarify how different variables are

related to one another.
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The Macroeconomics of Saving and
Investment
• Recall the composition of GDP (expenditure approach):
𝐘 = 𝐂 + 𝐈 + 𝐆 + 𝐍𝐗
• Assuming a closed economy with no interaction with the rest of the
world: 𝐍𝐗 = 𝟎. Hence, we get:
𝐘 = 𝐂 + 𝐈 + 𝐆
Total value of Output Total value of
or Income Expenditure

• This is an accounting identity of national income.

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Investment
• Investment (I) (used in economics) refers to the purchase of
new capital, such as equipment or buildings (including houses
of consumers).
• Note: financial investment is a purchase of corporate stocks, bonds, or
other financial assets, so it is not considered as investment.
• Increase or decrease of inventory – produced in a given year
may be sold in a later time – is also counted as part of
investment.

33
Government Purchases (G) and
Consumption (C)
• Government purchases (G): All spending on the goods and services
purchased by the government. This is funded by taxes (T)
• Government spendings can be further classified as consumption or investment.
• Excludes transfer payments (TR) (directly giving money to the citizens).
Example: Vietnam government subsidies over-80 elderlies ~4 million VND a
month.

• Consumption (C): Total spending by households on goods and

services.

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Vietnam Example of Y = G + I + C
VIETNAM GDP BY EXPENDITURE (EXCLUDE NX) (2020)

I: Investment
32.8%

C: Household's
Consumption
57.5% G: Government's
Spending
9.7%

Note: for the education purpose, the net export is not included in this graph.
Sources: GSO. 35
Why national income accounting is
important?
• Accounting identity is helpful to do economic analysis.
• Assumed that an economy has not reached its full capacity, any changes in GDP
must involve changes in all three components that add up to the overall change.
• GDP grows by 7%, it can be induced by:
• C increase by 7%.
• I increase by 7%.
• G increase by 7%.
• During the massive Covid lockdown in 2020 and 2021, the C component – the
willingness to consume by households – decreased. GDP growth rate of Vietnam
declined (from 7.4% to 2.9%).

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 Vietnam pre-Covid’s vs Covid’s years

2019 2020
Overall GDP Growth Rate 7.4% 2.9%
contributions from growth rates of:
I : Investment 7.5% 4.1%
G: Government's Spending 5.4% 1.2%
C: Households' Consumption 7.0% 0.4%
Sources: GSO

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Saving (S)
• In macroeconomics, savings (S) is defined as part of total income (Y)
that is not used for consumption. In other words, the total (national)
saving:
S=Y−C−G
• Therefore, in a closed economy (Y = C + G + I), savings must always
equal investments:
S=I
• This is also an accounting identity. Implication?

38
 The macroeconomics of Saving and
Investment
• Trade-off of higher saving rates:
Positive long-run economic impact.
Higher saving rates implies Increase in capital stock, higher labor producti
higher investment. vity, increase in R&D
→ Higher consumption in the future

Higher saving rates also implies Negative short-run economic impact

lower consumption today. → Decrease in demand for goods and services

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Differences in Investment Rates among
Selected Countries
Gross Capital Formation - approximately as Investment (I) (% of
GDP) in 2019

43.3

30.2 31.5
25.8
23.3 23.8
21.0 21.4 22.1
17.9 18.2

UK Italy Malaysia United Germany Australia Thailand Japan India South China
States Korea
Sources: World Bank 40
“According to the IMF, China
generated 28 per cent of total
global savings in 2023”.
Problems:
• Overcapacity → fierce
competition and wasted
production capacity.
• Overinvestment on housings
without owners or
infrastructure without users.
• Pressure on other countries to
absorb China’s savings.

You can read a bit at

https://vnexpress.net/ap-luc-san-xuat-du-
thua-o-trung-quoc-4729641.html
Government budget

• 𝐆 > 𝐓: Budget deficit.

• 𝐆 = 𝐓: Budget balance.
• 𝐆 < 𝐓: Budget surplus.
Budget deficit and government debt
• Government issues government bonds to finance its budget
deficit.
• Most of countries are running budget deficit.
• The entire amount of government bonds outstanding,
representing the accumulation of past government deficits, is
the government debt.

43
Government Debt as % GDP

Vietnam’s government debt is at

43.1% of GDP in 2021.
Sources: Ministry of Finance

44
The Relationship between Savings and
Investments
• We can further categorize savings:
Saving (𝑆) = Private Saving (𝑆𝑝𝑟𝑖𝑣𝑎𝑡𝑒 ) + Public Saving (𝑆𝑝𝑢𝑏𝑙𝑖𝑐 )

• Or:
𝑆 =𝑌−𝐶−𝐺−𝑇+𝑇
𝑆 = 𝑌−𝑇−𝐶 + 𝑇−𝐺
𝑆= 𝑆𝑝𝑟𝑖𝑣𝑎𝑡𝑒 + 𝑆𝑝𝑢𝑏𝑙𝑖𝑐

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The Market for Loanable
Funds
Theory of Market for Loanable Funds
Now we will study how the funds from savings and
investments are traded in the market.

Households’ savings Households and Firms’ investments

• Willingness to lend at a price • Willingness to borrow at price

(interest rate) (interest rate)
• Higher interest rates, higher su • Higher interest rate lower the de
pply of loanable funds mand for loanable funds

Upward-slopping supply of Downward-slopping demand for

loanable funds loanable funds
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Market for Loanable funds
• Demand for loanable funds Real
Interest
Rate (r)
• The demand for loanable
r2
funds (DLF) comes from the
r1
investment (I) of firms.
DLF
• The demand curve is downward (for Ig )
sloping because a higher interest 0 Q2LF Q1LF Quantity of
rate discourages borrowing to Loanable Funds (QLF)

finance (new) capital projects.

48
Market for Loanable funds
• Supply of loanable funds
Real
• The supply of loanable funds (SLF) Interest SLF
Rate (r) (from national
comes from people who have some saving)
r2
extra income and want to save (and
lend out). r1
• The supply curve is upward sloping
because individuals will save (supply
loanable funds) more if the real interest 0 Q1LF Q2LF Quantity of
rate is high, and vice versa. Loanable Funds (QLF)

49
Market for Loanable funds: Equilibrium
(1)
Real Iinterest Supply (S)
Rate (%)

..................................
r*

Demand (D)

Q* Quantiy of Loanable Funds (QLF)

50
Market for Loanable funds: Equilibrium
(2)
• Like any market, the price of the loanable funds (the real
interest rate) adjusts to reach the equilibrium as demand and
supply of loanable funds meet.
• If 𝐫 > 𝒓𝒆𝒒 , the surplus of loanable funds (𝐐𝐒𝐋𝐅 > 𝐐𝐃
𝐋𝐅 ) will drive the real
interest rate to move downward to the equilibrium level.
• If 𝐫 < 𝒓𝒆𝒒 , the shortage of loanable funds (𝑸𝑺𝑳𝑭 < 𝑸𝑫
𝑳𝑭 ) will push the real
interest rate upward to move to the equilibrium level.

51
Governmental Policies

How can government affect the market of

loanable funds?

52
Policy 1: Taxes and Saving
• People respond to incentives.
• Taxes on interest income:
• Substantially reduce the future pay-off from current saving and, as a
result, reduce the incentive to save.
• Hence, a tax cut decreases the incentive for households to save at any
given interest rate and vice versa.

53
Interest Income vs Other Incomes
• Interest income: the money obtains from deposit accounts (at
banks), government bonds, or corporate bonds (from firms).
• Other incomes: salary income, capital gains (investment
income), rents …

54
A Decrease in Interest Income Tax
Interest rate
• Change in tax → change in (%)
Supply, S1
saving → shift in supply of S2
loanable funds A B
r1
C
• Decrease in income tax → r2

saving more → Supply of

Demand, D
loanable funds shifts to the
Q1 Q2 Q3 Loanable funds
right

56
A Decrease in Interest Income Tax (2)
Interest rate
• As result, the market (%)
Supply, S1
equilibrium will move to the S2
new one (point C) from the A B
r1
old one (point A) C
r2

• Interest rate falls

Demand, D
• Quantity of loanable fund
increases Q1 Q2 Q3 Loanable funds

57
A Decrease in Interest Income Tax (3)
Interest rate
• Cutting income tax could (%)
Supply, S1
encourage greater saving, S2
which in turn reduces interest A B
r1
rate and leads to greater C
r2

investment.
Demand, D

Q1 Q2 Q3 Loanable funds

58
Policy 2: Taxes and investment
• An investment tax credit increase the incentive to borrow.
• Investment tax credit: the policy individuals or businesses deduct a
certain percentage of investment costs from their taxes.
• Example: investing on solar energy gets 26% tax credit in the US.

• If a change in tax laws encourages greater investment, the result

will be higher interest rates and greater saving.

59
An Investment Tax Credit
Interest
• An investment tax credit → rate (%)
Supply, S1
Increase in investment →
C
r2
Increase in demand for A
B
r1
loanable funds → Demand
for loanable funds shifts to D2
the right Demand, D

Q1 Q2 Q3 Loanable funds

61
An Investment Tax Credit (2)
Interest
• As result, the market rate (%)
Supply, S1
equilibrium will move to
C
r2
the new one (point C) A
B
r1
from the old one (point
A) D2
• Interest rate rises Demand, D

• Quantity of loanable fund

Q1 Q2 Q3 Loanable funds
rises

62
An Investment Tax Credit (3)
Interest
• A change in tax law rate (%)
Supply, S1
(introducing an investment
C
r2
tax credit) could encourage A
B
r1
greater investment, the
result would be higher D2
interest rates and greater Demand, D

saving.
Q1 Q2 Q3 Loanable funds

63
Policy 3: Government budgets – Surplus
or Deficit
• Assumption: Government competes with businesses for fixed
saving.
• Government’s borrowing to finance its budget deficit reduces the
supply of loanable funds available to finance investment by firms.
• The corresponding fall in investment is referred to as the
crowding-out effect.
• Budget deficit decreases the supply of loanable funds.

64
The Effect of a Government Budget
Deficit
Interest
rate (%)
Budget deficit → negative S2

public saving → lowering Supply, S1

national saving (S) → C

r2
reducing S of loanable funds r1
A
B
→ shift the S curve to the left.

Demand, D

Q3 Q2 Q1 Loanable funds

65
The Effect of a Government Budget
Deficit – Crowding out
Interest
• Increase in S of LF leads to rate (%)
S2
an increase in interest rate. Supply, S1

This in turn discourages C

some demanders of LF r2
B
r1 A

• → The fall in investment is

called “crowding-out
Demand, D
effect”
Q3 Q2 Q1 Loanable funds
66
The Effect of a Government Budget
Deficit (2)
Interest
As result, the market rate (%)
S2
equilibrium will move to Supply, S1

the new one (point C) from C

the old one (point A) r2
B
r1 A
• Interest rate rises
• Quantity of loanable fund
rises Demand, D

Q3 Q2 Q1 Loanable funds
67
The Effect of a Government Budget
Deficit (3)
Interest
When the government rate (%)
S2
reduces national saving by Supply, S1

running a budget deficit, C

the real interest rate rises r2
B
r1 A
and investment falls.

Demand, D

Q3 Q2 Q1 Loanable funds
68
In a nutshell, the Theory of Market for
Loanable Funds says:
• From I = S = 𝑆𝑝𝑟𝑖𝑣𝑎𝑡𝑒 + T − G , we can:
I by S𝑝𝑟𝑖𝑣𝑎𝑡𝑒 or,
by T − G (less budget deficit)
• The government can affect the levels of investment through encouraging more
private saving by:
• Lower income tax rates.
• Provide investment tax credits.
• Lower the (annual) levels of budget deficit.

• This is the perspective of Classical Economics (a school of economic thought).

69
From the perspective of Keynesian
Economics:
• Assumption: private investment (I) drives the total income (Y).
• When total income (Y) goes up, saving (S) follows. Government
spending (G) helps to sustain a high level of investment and
income; and the total saving will adjust accordingly:
• Crowding-out effect only partially happens when the economy is
NOT under full capacity.
• We will learn more about the role of the government on Week 10
when discussing fiscal policy.

70
Crowding-out effect debate
https://www.ft.com/content/fc780e65-dff7-41fb-85cd-b12ee89bdfe6

71
Summary
• The financial system is made of financial institutions such as the
bond market, the stock market, banks and other financial
institutions.
• 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.
• National income accounting identities reveal that in a closed
economy, national saving must equal investment (𝐼 = 𝑆).
72
Summary (2)
• The interest rate is determined by the supply and demand for
loanable funds.
• Policies on income taxes and investment tax credit can induce more
investment in the economy.
• A government budget deficit represents negative public saving and,
therefore, reduces national saving and the supply of loanable funds.
• When a government budget deficit crowds out investment, it
(debatably) reduces the growth of productivity and GDP.

73
The Relationship between Savings and
Investment (1)
• Private saving is the amount of income that households have
left after paying their taxes and spending on their consumption.
• It is equal to households’ disposable income that is not used for
consumption:

• Y = income
Sprivate = Y + TR − T − C • TR = transfers
Disposable income • T = taxes
• C = consumption

74
The Relationship between Savings and
Investment (2)
• Public saving is the amount of tax revenue that the government
has left after paying for its spending.
• It is equal to government’s tax revenue minus transfers minus
expenditure:

• T = taxes
Spublic = T − TR − G • TR = transfers
• G = government ′ s spending on
good and services
75
The Relationship between Savings and
Investment (3)
• Note further on the public saving that:
• Whenever 𝐓 > 𝐆 + 𝐓𝐑, the government runs a budget surplus because
it receives tax revenue more than it spends.
• But if 𝐓 < 𝐆 + 𝐓𝐑, the government runs a budget deficit because it
spends more money than it receives as taxes.
• If government spending equals tax revenue (𝐓 − 𝐓𝐑 = 𝐆), the
government has a balanced budget.

76
The Relationship between Savings and
Investment (4)
• Saving must always equal investment:
I = S = Sprivate + Spublic
I = Sprivate + T − G − TR
Disposable Income

with Sprivate = Y + TR − T − C.
• This is an identity accounting (hold true by definition).

77