Saving, Investment,

and the Financial

System

18

Context
Continue with a sequence of topics which deal with the
production of output in the long run.
In the previous lecture, we found that capital and labor are
among the primary determinants of output.
The purpose of the present lecture is to show how saving
and investment are coordinated by the loanable funds
market.
Within the framework of the loanable funds market, we will
study the effects of taxes and government deficits on

saving,
investment,
the accumulation of capital,
the growth rate of output.

The Financial System

The financial system consists of the group of
institutions in the economy that help to match one
persons saving with another persons investment.
It moves the economys scarce resources from savers to
borrowers.

FINANCIAL INSTITUTIONS IN THE U.S.

ECONOMY

The financial system is made up of financial

institutions that coordinate the actions of
savers and borrowers.
Financial institutions can be grouped into two
different categories:
financial markets and
financial intermediaries.

FINANCIAL INSTITUTIONS IN THE U.S.

ECONOMY
Financial markets are the institutions through which
savers can directly provide funds to investors.
Stock Market
Bond Market

Financial intermediaries are financial institutions

through which savers can indirectly provide funds to
investors.
Banks
Mutual Funds

Financial Markets
The Bond Market
A bond is a certificate of indebtedness that
specifies obligations of the borrower to
the holder of the bond.
Characteristics of a Bond

IOU

Rate of interest that will be paid periodically until the loan

matures.
Term: The length of time until the bond matures.
All else equal, long-term bonds pay higher rates of interest than short-term bonds.

Credit Risk: The probability that the borrower will fail to pay
some of the interest or principal.
All else equal, the more risky a bond is, the higher its interest rate.

Tax Treatment: The way in which the tax laws treat the interest
on the bond.
Municipal bonds are federal tax exempt.

Financial Markets
The Stock Market
Stock represents a claim to partial ownership in a firm
and is therefore, a claim to the profits that the firm
makes.
The sale of stock to raise money is called equity
financing.
The sale of bonds to raise money is called debt financing
Compared to bonds, stocks offer both higher risk and
potentially higher returns.

The most important stock exchanges in the United States

are the New York Stock Exchange, the American Stock
Exchange, and NASDAQ.

Financial Markets
The Stock Market
Most newspaper stock tables provide the following
information:
Price (of a share)
The price of a stock generally reflects the perception of a companys future
profitability.

Volume (number of shares sold)

Dividend (profits paid to stockholders)
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.

The Stock Market (cont)

Earnings per share is the company's total earnings divided
by the number of shares of stock outstanding.
The price-earnings ratio (P/E), is the price of a
corporation's stock divided by the amount the corporation
earned per share over the past year.
Historically, the typical price-earnings ratio is about 15.
High 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.

Low P/E indicates that a corporation's stock is cheap relative to its

recent earnings;
this might indicate either that people expect earnings to fall or that the stock
is undervalued.

Financial Intermediaries

Financial intermediaries are financial

institutions through which savers can
indirectly provide funds to borrowers.
Banks
Mutual funds.

Financial Intermediaries: Role of Banks

Their primary role is to take deposits from people who want
to save and use the deposits to make loans to people who
want to borrow.
Pay depositors interest on their deposits and charge
borrowers a higher rate of interest to cover the costs of
running the bank and provide the bank owners with some
amount of profit
Create a medium of exchange by providing checking
accounts and allowing people to write checks against their
deposits.
A medium of exchanges is an item that people can easily use to
engage in transactions.

This facilitates the purchases of goods and services.

Financial Intermediaries: Mutual Funds

A mutual fund is an institution that sells shares to
the public and uses the proceeds to buy a portfolio,
of various types of stocks, bonds, or both.
They allow people with small amounts of money to
easily diversify.

Index funds are mutual funds that buy all of the

stocks of a given stock index.
Generally perform better than funds with active fund
management.
they trade stocks less frequently and they do not have to pay the
salaries of fund managers.

Assignment
1. Assume you have $100,000 in savings.
2. Create a portfolio of securities worth $100,000.
3. Decide what financial instruments you would like to use, then
find their current prices in the newspaper.
4. Calculate your holdings of each security, based on current prices.
What objectives do you have for this portfolio? Was it chosen to
maximize short-term gains, long-term stability, or some other
objective?
Explain how each of the following economic events would affect
the value of your portfolio.

an increase or decrease in interest rates

a recession
rapid inflation
a depreciation of the U.S. dollar

Financial Intermediaries
Other Financial Institutions

Credit unions
Pension funds
Insurance companies
Loan sharks

SAVING AND INVESTMENT IN THE

NATIONAL INCOME ACCOUNTS

Recall:
GDP is both total income in an economy and total
expenditure on the economys output of goods
and services
GDP can be divided up into four components:
consumption, investment, government purchases, and
net exports.

Y = C + I + G + NX

Some Important Identities

Assume a closed economy

i.e., one that does not engage in international trade
This implies that GDP can now be divided into
only three components:

Y=C+I+G

Some Important Identities

Now, subtract C and G from both sides of the
equation:
Y C G =I
The left side of the equation is the total income in
the economy after paying for consumption and
government purchases and is called national saving,
or just saving (S).
Substituting S for Y - C - G, the equation can be
written as:
S=I

Some Important Identities

National saving, or saving, is equal to:
S=I
S=YCG
We can add and subtract taxes:
S = Y C G + T T
After rearrangement:
S = (Y T C) + (T G)
Two types of saving.

S = Sprivate + Spublic

The Meaning of Saving and Investment

National Saving
National saving is the total income in the economy that
remains after paying for consumption and government
purchases.

Private Saving
Private saving is the amount of income that households
have left after paying their taxes and paying for their
consumption.
Private saving = (Y T C)

The Meaning of Saving and Investment

Surplus and Deficit
If T > G, the government runs a budget surplus because
it receives more money than it spends.
Budget surplus: an excess of tax revenue over government
spending.
The surplus of T - G represents public saving.

If G > T, the government runs a budget deficit because it

spends more money than it receives in tax revenue.
Budget deficit: a shortfall of tax revenue from government
spending.
To make up for this shortfall, the government must go to the
loanable funds market and borrow the money.
This will reduce the supply of loanable funds available for
investment.

The Meaning of Saving and Investment

Public Saving
Public saving is the amount of tax revenue that the
government has left after paying for its spending.
Public saving = (T G)

An illustration
Suppose that GDP is $8 trillion, taxes are $1.5 trillion, private saving
is $0.5 trillion, and public saving is $0.2 trillion.
Assuming this economy is closed, calculate consumption, government
purchases, national saving, and investment.
Given that Y = 8 and T = 1.5,
Sprivate = 0.5 = Y T C,
Spublic = 0.2 = T G.
Since Sprivate = Y T C, then a rearrangement gives
C = Y T Sprivate = 8 1.5 0.5 = 6.
Since Spublic = T - G, then rearranging gives
G = T Spublic = 1.5 0.2 = 1.3.
Since S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7.
Finally, since I = investment = S, I = 0.7.

THE MARKET FOR LOANABLE FUNDS

Coordination of the economys saving and investment
occurs in the market for loanable funds.
The market for loanable funds (LF) is the market in which those
who want to save supply funds and those who want to borrow
(and invest) demand funds.

LF is all income that people have chosen to save and lend

out, rather than use for their own consumption.
The supply of LF comes from people who have extra income they
want to save and lend out.
They buy stocks and bonds

The demand for LF comes from households and firms that wish to
borrow to make investments.
Families borrow to invest in new homes while firms may borrow to purchase
new equipment or to build factories.

The Meaning of Saving and Investment

Outside of the economics profession, most people use
the terms saving and investing interchangeably.
In macroeconomics, investment refers to the purchase of
new capital, such as equipment or buildings.

What is the meaning of the identity: S = I ?

For the economy as a whole, saving must be equal to
investment.
The bond market, the stock market, banks, mutual funds, and
other financial markets and institutions stand between the two
sides of the S = I equation.
These markets and institutions take in the nation's saving and
direct it to the nation's investment.

Supply and Demand for Loanable Funds

Markets for loanable funds work much like other
markets in the economy.
The equilibrium of the supply and demand for loanable
funds determines the price of a loan

The real interest rate is the price of the loan.

It represents the amount that borrowers pay for loans and
the amount that lenders receive on their saving.

Figure 1 The Market for Loanable Funds

Interest
Rate

Supply/Saving

Demand/Investing

Loanable Funds
(in billions of dollars)

All else equal, as the interest rate rises, the quantity of loanable funds supplied will
increase.
All else equal, as the interest rate rises, the quantity of loanable funds demanded
will fall.

Figure 1 The Market for Loanable Funds

Interest
Rate

Supply/Saving
If the quantity of funds demanded is smaller than the quantity
of funds supplied, lenders would compete for borrowers,
driving the interest rate down.

5%

If the quantity of funds demanded is greater than the

quantity of funds supplied, the shortage of loanable
funds would encourage lenders to raise the interest rate.

Demand/Investing

$1,200

Loanable Funds
(in billions of dollars)

Supply and Demand for Loanable Funds

Government Policies That Affect Saving and
Investment
Saving incentives
Investment Incentives
Government budget deficits

Policy 1: Saving Incentives

Taxes on interest income substantially reduce the
future payoff from current saving and, as a result,
reduce the incentive to save.
A tax reduction increases the incentive for
households to save at any given interest rate.
The loanable funds supply curve shifts to the right.
The equilibrium interest rate decreases.
The quantity demanded for loanable funds increases.

Figure 2 An Increase in the Supply of Loanable

Funds
Interest
Rate

Supply, S1

S2

1. Tax incentives for

saving increase the
supply of loanable
funds . . .

5%
4%
2. . . . which
reduces the
equilibrium
interest rate . . .

Demand

$1,200

$1,600

3. . . . and raises the equilibrium

quantity of loanable funds.

Loanable Funds
(in billions of dollars)

Policy 1: Saving Incentives

Conclusion?
If a change in tax law encourages greater saving,
the result will be lower interest rates and greater
investment.

Policy 2: Investment Incentives

An investment tax credit increases the incentive to
borrow.
Reduces taxes for any firm building a new factory or
buying a new piece of equipment
=>Increases the demand for loanable funds.
=>Shifts the demand curve to the right.
=>Results in a higher interest rate and a greater quantity
saved.

If a change in tax laws encourages greater

investment, the result will be higher interest rates
and greater saving.

An Increase in the Demand for Loanable Funds

Interest
Rate

Supply
1. An investment
tax credit
increases the
demand for
loanable fund s . . .

6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .

D2
Demand, D1

$1,200

$1,400

3. . . . and raises the equilibrium

quantity of loanable funds.

Loanable Funds
(in billions of dollars)

Policy 3: Government Budget Deficits and

Surpluses
When the government spends more than it receives
in tax revenues, the shortfall is called the budget
deficit.
The accumulation of past budget deficits is called
the government debt.
Government borrowing to finance its budget deficit
reduces the supply of loanable funds available to
finance investment by households and firms:
SPublic => S
Which curve does this affect?

Policy 3: Government Budget Deficits and

Surpluses
A budget deficit decreases the supply of loanable
funds.
Shifts the supply curve to the left.
Increases the equilibrium interest rate.
Reduces the equilibrium quantity of loanable funds.

Figure 4: The Effect of a Government Budget

Deficit
Interest
Rate

S2

Supply, S1

1. A budget deficit
decreases the
supply of loanable
funds . . .

6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .

Demand

$800

$1,200

Loanable Funds
(in billions of dollars)

3. . . . and reduces the equilibrium

quantity of loanable funds.
Copyright2004 South-Western

Policy 3: Government Budget Deficits and

Surpluses
When government reduces national saving by
running a deficit, the interest rate rises and
investment falls.
This fall in investment is referred to as crowding
out.
The deficit borrowing crowds out private borrowers who
are trying to finance investments.
SPrivate + SPublic = S = I .

A budget surplus increases the supply of loanable

funds, reduces the interest rate, and stimulates
investment.

The U.S. Government Debt

Percent
of GDP
120
World War II
100

80

60

Revolutionary
War

Civil
War

World War I

40

20

0
1790

1810

1830

1850

1870

1890

1910

1930

1950

1970

1990

2010

Copyright2004 South-Western

The U.S. Government Debt

In recent years, government debt has been about 50
percent of GDP.
Throughout history, the primary cause of
fluctuations in government debt has been wars.
However, the U.S. debt also increased substantially
during the 1980s when taxes were cut but
government spending was not.
By the late 1990s, the debt to GDP ratio began
declining due to budget surpluses.
As of 2002, the Congressional Budget Office was
projecting that the debt-GDP ratio would decline
over the next decade to reach 15 percent in 2012.

12-2007
01-2008
02-2008
03-2008
04-2008
05-2008
06-2008
07-2008
07-2008
08-2008
09-2008
10-2008
11-2008
12-2008
01-2009
02-2009
03-2009
04-2009
05-2009
06-2009
07-2009
08-2009
09-2009
10-2009
11-2009
12-2009

% of labor force

The Financial Crisis of 20082009

A financial crisis led to a deep recession in the U.S.

and around the world. A few unemployment rates:
11

10

USA
France
U.K.
Canada
Sweden

FYI:

Elements of Financial Crises

Large decline in some asset prices

20082009: Housing prices fell 30%.

Insolvencies at financial institutions

20082009:
Banks and other institutions failed when many
homeowners stopped paying their mortgages.

Decline in confidence in financial

institutions
20082009:
Customers with uninsured deposits began
pulling their funds out of financial institutions.

FYI:

Elements of Financial Crises

Credit crunch
20082009: Borrowers unable to get loans
because troubled lenders not confident in
borrowers credit-worthiness.

Economic downturn
20082009: Failing financial institutions and
a fall in investment caused GDP to fall and
unemployment to rise.

Vicious circle
20082009: The downturn reduced profits
and asset values, which worsened the crisis.

CNN Video: A Matter of Priorities

There are many, including President Bush, who
argue for a tax cut. What are their arguments?
The arguments for the tax cuts are twofold.
because of the economic slowdown, a tax cut is needed to
stimulate the economy.
the surplus arises because taxpayers have overpaid, i.e.,
provided more money than was needed to finance the activities
of the government.

Do taxpayers benefit if the debt is repaid?

Who decides how the surplus is going to be used?

Summary
The U.S. financial system is made up of financial
institutions such as the bond market, the stock
market, banks, and mutual 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.

Summary
National income accounting identities reveal some
important relationships among macroeconomic
variables.
In particular, in a closed economy, national saving
must equal investment.
Financial institutions attempt to match one persons
saving with another persons investment.

Summary
The interest rate is determined by the supply and
demand for loanable funds.
The supply of loanable funds comes from
households who want to save some of their income.
The demand for loanable funds comes from
households and firms who want to borrow for
investment.

Summary
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.
When a government budget deficit crowds out
investment, it reduces the growth of productivity
and GDP.