24 FINANCE, SAVING

AND
INVESTMENT
After studying this chapter, you will be able to:
 Describe the flow of funds in financial markets
 Explain how financial decisions are made and the
risks that arise from these decisions
 Explain how lending and borrowing decisions
interact in financial markets
 Explain how governments influence financial
markets

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 Financial Markets and
Financial Institutions
To study the economics of financial institutions and
markets we distinguish between
 Finance and money
 Physical capital and financial capital
Finance and Money
The study of finance looks at how households and firms
obtain and use financial resources and how they cope with
the risks that arise in this activity.
The study of money looks at how households and firms
use it, how much of it they hold, how banks create and
manage it, and how its quantity influences the economy.
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 Financial Markets and
Financial Institutions
Capital and Financial Capital
Capital (or physical capital) is the tools, instruments,
machines, buildings, and other items that have been
produced in the past and that are used today to produce
goods and services.
The funds that firms use to buy physical capital are called
financial capital.

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 Financial Markets and
Financial Institutions
Capital and Investment
Gross investment is the total amount spent on purchases
of new capital and on replacing depreciated capital.
Depreciation is the decrease in the quantity of capital that
results from wear and tear and obsolescence.
Net investment is the change in the quantity of capital.
Net investment = Gross investment  Depreciation.

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 Financial Markets and
Financial Institutions
Figure 24.1 illustrates the
relationships among the
capital, gross investment,
depreciation, and net
investment.

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 Financial Markets and
Financial Institutions
Wealth and Saving
Wealth is the value of all the things that people own.
Saving is the amount of income that is not paid in taxes or
spent on consumption goods and services.
Saving increases wealth.
Wealth also increases when the market value of assets
rises—called capital gains—and decreases when the
market value of assets falls—called capital losses.

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 Financial Markets and
Financial Institutions
Financial Capital Markets
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

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 Financial Markets and
Financial Institutions
Financial Institutions
A financial institution is a firm that operates on both
sides of the markets for financial capital.
It is a borrower in one market and a lender in another.
Key financial institutions are
 Commercial banks
 Government-sponsored mortgage lenders
 Mutual funds
 Pension funds
 Insurance companies
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 Financial Markets and
Financial Institutions
Funds that Finance Investment
Funds come from three sources:
1. Household saving S
2. Government budget surplus (T – G)
3. Borrowing from the rest of the world (M – X)
Figure 24.2 on the next slide illustrates the flows of funds
that finance investment.

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Financial Markets and
Financial Institutions

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 Financial Decisions and Risk

Financial markets and institutions enable us to make

decisions about the timing of our use of scarce resources,
and to manage the risks that arise from these decisions.
The Time Value of Money
To compare current and future dollars, we convert future
dollars, called “future value,” to current dollars, called
“present value.”
Present value of Future amount, n years in the future when
the interest rate is r percent equals
Future amount ÷ (1 + r)n

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 Financial Decisions and Risk

Net Present Value

Net present value is the present value of all the future
flows of money that arise from a financial decision minus
the initial cost of the decision.
An example:
Jack can make a game bot for $500 and sell it after two
years for $2,420. The interest rate is 10 percent a year.
The present value of $2,420 two years in the future is
$2,420 ÷ (1 + 0.1)2, which is $2,000.
The net present value of Jack’s bot equals $2,000 – $500,
or $1,500.
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 Financial Decisions and Risk

Decision Rule
The financial decision rule is:
If the net present value is positive, do it!
If the net present value is negative, don’t do it!
Following this decision rule maximizes wealth when the
future money flows are not risky.
Where the future is uncertain, the rule is modified to:
Do it if the net present value is large enough to make a
loss sufficiently unlikely.

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 Financial Decisions and Risk

Financial Risk: Insolvency and Illiquidity

A financial institution’s net worth is the total market value
of what it has lent minus the market value of what it has
borrowed.
If net worth is positive, the institution is solvent and can
remain in business.
But if net worth is negative, the institution is insolvent and
must go out of business.

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 Financial Decisions and Risk

Market Risk: Interest Rates and Asset Prices

The interest rate on a financial asset equals the interest
received expressed as a percentage of the price of the
asset.
For example, if the price of the asset is $50 and the
interest is $5, then the interest rate is 10 percent.
If the asset price rises (say to $200), other things
remaining the same, the interest rate falls (2.5 percent).
If the asset price falls (say to $20), other things remaining
the same, the interest rate rises (to 25 percent).

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 Financial Decisions and Risk

Getting Real
An economy with inflation has two interest rates: the
nominal interest rate and the real interest rate.
The nominal interest rate is the number of dollars that a
borrower pays and a lender receives in interest in a year
expressed as a percentage of the dollars borrowed and
lent.
For example:
If the annual interest paid on a $500 loan is $25, the
nominal interest rate is 5 percent per year.

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 Financial Decisions and Risk

The real interest rate is the nominal interest rate adjusted

to remove the effects of inflation on the buying power of
money.
The real interest rate is approximately equal to the nominal
interest rate minus the inflation rate.
For example:
If the nominal interest rate is 5 percent a year and the
inflation rate is 2 percent a year, then the real interest rate
is 3 percent a year.
The real interest rate is the opportunity cost of borrowing.

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 The Loanable Funds Market

The market for loanable funds is the aggregate of all the

individual financial markets.
The market for loanable funds determines the real interest
rate, the quantity of funds loaned, saving, and investment.
We’ll start by ignoring the government and the rest of the
world.
The Demand for Loanable Funds
The quantity of loanable funds demanded depends on
1. The real interest rate
2. Expected profit
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 The Loanable Funds Market

Demand for Loanable Funds Curve

The demand for loanable funds is the relationship
between the quantity of loanable funds demanded and the
real interest rate when all other influences on borrowing
plans remain the same.
Business investment is the main item that makes up the
demand for loanable funds.

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 The Loanable Funds Market

Figure 24.3 shows the

demand for loanable funds
curve.
A rise in the real interest
rate decreases the quantity
of loanable funds
demanded.
A fall in the real interest rate
increases the quantity of
loanable funds demanded.

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 The Loanable Funds Market

Changes in the Demand for Loanable Funds

When the expected profit changes, the demand for
loanable funds changes.
Other things remaining the same, the greater the expected
profit from new capital, the greater is the amount of
investment and the greater the demand for loanable funds.

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 The Loanable Funds Market

The Supply of Loanable Funds

The quantity of loanable funds supplied depends on
1. The real interest rate
2. Disposable income
3. Expected future income
4. Wealth
5. Default risk

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 The Loanable Funds Market

The Supply of Loanable Funds Curve

The supply of loanable funds is the relationship between
the quantity of loanable funds supplied and the real
interest rate when all other influences on lending plans
remain the same.
Saving is the main item that makes up the supply of
loanable funds.

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 The Loanable Funds Market

Figure 24.4 shows the

supply of loanable funds
curve.
A rise in the real interest rate
increases the quantity of
loanable funds supplied.
A fall in the real interest rate
decreases the quantity of
loanable funds supplied.

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 The Loanable Funds Market

Changes in the Supply of Loanable Funds

A change in disposable income, expected future income,
wealth, or default risk changes the supply of loanable
funds.
An increase in disposable income, a decrease in expected
future income, a decrease in wealth, or a fall in default risk
increases saving and increases the supply of loanable
funds.

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 The Loanable Funds Market

Equilibrium in the Loanable Funds Market

The loanable funds market is in equilibrium at the real
interest rate at which the quantity of loanable funds
demanded equals the quantity of loanable funds supplied.

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 The Loanable Funds Market

Figure 24.5 illustrates the

loanable funds market.
At 4 percent a year, there is
a surplus of funds and the
real interest rate falls.
At 2 percent a year, there is
a shortage of funds and the
real interest rate rises.
Equilibrium occurs at a real
interest rate of 3 percent a
year.

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 The Loanable Funds Market

Changes in Demand and Supply

Financial markets are highly volatile in the short run but
remarkably stable in the long run.
Volatility comes from fluctuations in either the demand for
loanable funds or the supply of loanable funds.
These fluctuations bring fluctuations in the real interest
rate and in the equilibrium quantity of funds lent and
borrowed.
They also bring fluctuations in asset prices.

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 The Loanable Funds Market

Figure 24.6(a) illustrates an

increase in the demand for
loanable funds.
An increase in expected
profits increases the
demand for funds today.
The real interest rate rises.
Saving and quantity of
funds supplied increases.

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 The Loanable Funds Market

Figure 24.6(b) illustrates

an increase in the supply
of loanable funds.
If one of the influences on
saving plans changes and
saving increases, the
supply of funds increases.
The real interest rate falls.
Investment increases.

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 Government in the Loanable Funds
Market
Government enters the loanable funds 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.

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 Government in the Loanable Funds
Market
Figure 24.7 illustrates the
effect of a government
budget surplus.
A government budget
surplus increases the supply
of funds.
The real interest rate falls.
Investment increases.
Private saving decreases.

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 Government in the Loanable Funds
Market
Figure 24.8 illustrates the
effect of a government
budget deficit.
A government budget
deficit increases the
demand for funds.
The real interest rate rises.
Private saving increases.
Investment decreases—is
crowded out.

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 Government in the Loanable Funds
Market
Figure 24.9 illustrates the
Ricardo-Barro effect.
A budget deficit increases
the demand for funds.
Rational taxpayers increase
saving, which increases the
supply of funds.
Increased private saving
finances the deficit.
Crowding-out is avoided.

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