Chap 26

N. Gregory Mankiw & Mohamed H.
Rashwan
Economics
Principles of
Arab World Edition
Chapter 26
Saving, Investment,
and the Financial System
To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3 rd edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
In this chapter, look for the answers to these
questions:
• What are the main types of financial institutions

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?
1
FINANCIAL INSTITUTIONS
 The financial system: the group of institutions
that helps match the saving of one person with the
investment of another.
 Various institutions help to co-ordinate this market
by bringing together savers and borrowers.
 Financial institutions can be grouped into:
 Financial markets.
 Financial intermediaries.
 We shall explore these in the next two slides.
2
Financial Markets
 Financial markets: institutions through which
savers can directly provide funds to borrowers.
Examples:
 The Bond Market.
 A bond is a certificate of indebtedness.
 The Stock Market.
 A stock is a claim to partial ownership in a firm.
3
Financial Intermediaries
 Financial intermediaries: institutions through
which savers can indirectly provide funds to
borrowers. Examples include:
 Banks.
 Mutual funds – institutions that sell shares to the
public and use the proceeds to buy portfolios of
stocks and bonds.
4
The Financial Crisis of 2008–2009
 A financial crisis led to a deep recession in the U.S.
and around the world. A few unemployment rates:
11
10
9
% of labor force
7
USA
6 France
5 U.K.
Canada
4
Sweden
3
12-2007
01-2008
02-2008
03-2008
04-2008
06-2008
07-2008
07-2008
08-2008
10-2008
11-2008
12-2008
01-2009
02-2009
04-2009
05-2009
06-2009
07-2009
08-2009
09-2009
10-2009
11-2009
12-2009
05-2008
09-2008
03-2009
FYI: Elements of Financial Crises
 Large decline in some asset prices
 2008–2009: Housing prices fell 30%.
 Insolvencies at financial institutions.
 2008–2009: Banks and other institutions failed when
many homeowners stopped paying their mortgages.
 Decline in confidence in financial institutions.
 2008–2009: Customers with uninsured deposits
began pulling their funds out of financial institutions.
6
FYI: Elements of Financial Crises
 Credit crunch.
 2008–2009: Borrowers unable to get loans because
troubled lenders not confident in borrowers’ credit-
worthiness.
 Economic downturn.
 2008–2009: Failing financial institutions and a fall in
investment caused GDP to fall and unemployment to
rise.
 Vicious circle.
 2008–2009: The downturn reduced profits and asset
values, which worsened the crisis.
7
SAVINGS AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
Private saving
= The portion of households’ income that is not
used for consumption or paying taxes.
=Y–T–C
Public saving
= Tax revenue less government spending.
=T–G
8
Some Important Identities
National saving
= private saving + public saving.
= (Y – T – C) + (T – G)
= Y – C – G
= the portion of national income that is not used
for consumption or government purchases.
9
Some Important Identities
Recall the national income accounting identity:
Y = C + I + G + NX
For the rest of this chapter, focus on the closed
economy case:
Y=C+I+G
national saving
Solve for I:
I = Y–C–G = (Y – T – C) + (T – G)
Saving = investment in a closed economy
10
Budget Deficits and Surpluses
Budget surplus occurs when there is an excess

of tax revenue over government spending.
= T – G = public saving
Budget deficit occurs when there is a shortfall of
tax revenue from government spending.
= G – T = – (public saving)
11
ACTIVE LEARNING 1
A. Calculations
 Suppose:
 GDP equals $10 trillion.
 Consumption equals $6.5 trillion.
 The government spends $2 trillion
 The government has a budget deficit of $300
billion.
 Find public saving, taxes, private saving,
national saving, and investment.
ACTIVE LEARNING 1
Answers, part A
Given:
Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5
Investment = national saving = 1.5
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.
ACTIVE LEARNING 1
Answers, part B
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.
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?
The Meaning of Saving and Investment
 Private saving is the income remaining after
households pay their taxes and pay for
consumption.
 Examples of what households might do with
saving:
 Buy stock or bonds from a corporation.
 Deposit savings in the bank.
 Buy shares of a mutual fund.
 Let accumulate in saving or checking accounts.
17
The Meaning of Saving and Investment
 Investment is the purchase of new capital.
 Examples of investment:
 A large manufacturing company spends $250 million
to build a new factory.
 You buy $5000 worth of computer equipment for your
business.
 Your parents spend $300,000 to have a new house
built.
Remember: In economics, investment is NOT
the purchase of stocks and bonds!
18
THE MARKET FOR LOANABLE FUNDS
 A supply–demand model of the financial system
 Helps us understand:
 How the financial system coordinates
saving & investment.
 How government policies and other factors
affect saving, investment, the interest rate.
19
THE MARKET FOR LOANABLE FUNDS
Assume: Only one financial market
 All savers deposit their saving in this market.
 All borrowers take out loans from this market.
 There is one interest rate, which is both the
return to saving and the cost of borrowing.
20
The Supply for Loanable Funds
The supply of loanable funds comes from saving:
 Households with extra income can loan it out
and earn interest.
 Public saving, if positive, adds to national
saving and the supply of loanable funds.
If negative, it reduces national saving and the
supply of loanable funds.
21
The Slope of the Supply Curve
An increase in
Interest
Rate Supply
the interest rate
makes saving
more attractive,
6%
which increases
the quantity of
loanable funds
3% supplied.
60 80 Loanable Funds
($billions)
22
The Demand 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.
23
The Slope of the Demand Curve
A fall in the interest
Interest rate reduces the cost
Rate
of borrowing, which
7% increases the quantity
of loanable funds
demanded.
4%
Demand
($billions)
24
Equilibrium
The interest rate
Interest adjusts to equate
Rate Supply supply and demand.
The equilibrium
quantity of L.F.
5%
equals equilibrium
investment and
equilibrium
Demand
saving.
60 Loanable Funds (LF)
($billions)
25
Policy 1: Saving Incentives
Tax incentives for
Interest saving increase the
Rate S1 S2 supply of L.F.
…which reduces the

5%
equilibrium interest
rate and increases
4%
the equilibrium
quantity of L.F.
D1
($billions)
26
Policy 2: Investment Incentives
An investment tax
Interest credit increases the
Rate S1 demand for L.F.
6%
…which raises the
5% equilibrium interest
rate and increases
D2 the equilibrium
D1 quantity of L.F.
($billions)
27
ACTIVE LEARNING 2
Budget deficits
 Use the loanable funds model to analyze
the effects of a government budget deficit:
 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?
ACTIVE LEARNING 2
Answers
A budget deficit reduces
national saving and the
Interest S2 supply of L.F.
Rate S1
…which increases the
6% equilibrium interest
rate and decreases
5%
the equilibrium
quantity of L.F. and
investment.
D1
($billions)
Policy 3: Government Budget Deficits
and Surpluses
 Our analysis from Active Learning 2 Budget
deficits (previous slide): Increase in budget
deficit causes fall in investment.
 The government borrows to finance its deficit,
leaving less funds available for investment.
 This is called crowding out.
 Recall from the preceding chapter: Investment
is important for long-run economic growth.
Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
30
CONCLUSION
 Like many other markets, financial markets are
governed by the forces of supply and demand.
 One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
Financial markets help allocate the economy’s
scarce resources to their most efficient uses.
 Financial markets also link the present to the future:
They enable savers to convert current income into
future purchasing power, and borrowers to acquire
capital to produce goods and services in the future.
31
SU MMA RY
• The financial system is made up of many types

of financial institutions, like the stock and bond
markets, banks, and mutual funds.
• National saving equals private saving plus
public saving.
• In a closed economy, national saving equals
investment. The financial system makes this
happen.
SU MMA RY
• 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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N. Gregory Mankiw & Mohamed H.

Arab World Edition

• What are the main types of financial institutions

Saving = investment in a closed economy

Budget surplus occurs when there is an excess

Public saving = T – G = – 0.3

Taxes: T = G – 0.3 = 1.7

Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8

National saving = Y – C – G = 10 – 6.5 = 2 = 1.5

Investment = national saving = 1.5

 Which of these two scenarios do you think is

…which reduces the

• The financial system is made up of many types

• The supply of loanable funds comes from

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