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Lesson 5

Savings, Investment, and the Financial System


FINANCIAL INSTITUTIONS
 Financial system
 the group of institutions that helps match the saving of one person with the investment of
another.

 Financial markets
 institutions through which savers can directly provide funds to borrowers.
 Examples:
o The bond market - A bond is a certificate of indebtedness.
o The stock market - A stock is a claim to partial ownership in a firm.

 Financial intermediaries
 institutions through which savers can indirectly provide funds to borrowers.
 Examples:
o Banks
o Mutual funds – institutions that sell shares to the public and use the proceeds to buy
portfolios of stocks and bonds

DIFFERENT KINDS OF SAVINGS


 Private saving
 The portion of households’ income that is not used for consumption or paying taxes
Private saving = Y – T – C
Private saving = Household’s income – Taxes - Consumption

 Public saving
 Tax revenue less government spending
Public saving = T – G
Public saving = Taxes – Government Purchases

 National saving
 the portion of national income that is not used for consumption or government purchases
 Private saving + Public saving
National saving = (Y – T – C) + (T – G)
National saving = Y – C – G
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
Solve for I:
I=Y–C–G
I= (Y – T – C) + (T – G)
Saving = investment in a closed economy

 Budget surplus
 an excess of tax revenue over govt spending
 Formula: T – G = public saving

 Budget deficit
 a shortfall of tax revenue from govt spending
 Formula: T – G = (public saving)
THE MEANING OF SAVING AND INVESTMENT
 Private saving
 It is the income remaining after households pay their taxes and pay for consumption.
1
Lesson 5
Savings, Investment, and the Financial System
 Examples of what households do with saving:
 Buy corporate bonds or equities
 Purchase a certificate of deposit at the bank
 Buy shares of a mutual fund
 Let accumulate in saving or checking accounts

 Investment
 It is the purchase of new capital.
 Examples of investment:
 General Motors spends 250 million to build a new factory in Flint, Michigan.
 You buy 5000 worth of computer equipment for your business.
 Your parents spend 300,000 to have a new house built.
 In economics, investment is NOT JUST the purchase of stocks and bonds

 A supply–demand model of the financial system


 Helps us understand:
o how the financial system coordinates saving & investment.
o how government policies and other factors affect saving, investment, the interest rate.
 Assume: only one financial market
o All savers deposit their saving in this market.
o All borrowers take out loans from this market.
o There is one interest rate, which is both the return to saving and the cost of borrowing.
 The supply of loanable funds comes from saving:
o Households with extra income can loan it out and earn interest.
o Public saving, if positive, adds to national saving and the supply of loanable funds.
o If negative, it reduces national saving and the supply of loanable funds.
 An increase in the interest rate makes saving more attractive, which increases the quantity of
loanable funds supplied.
 The demand for loanable funds comes from investment:
o Firms borrow the funds they need to pay for new equipment, factories, etc.
o Households borrow the funds they need to purchase new houses.
 A fall in the interest rate reduces the cost of borrowing, which increases the quantity of
loanable funds demanded.

Budget Deficits, Crowding Out, and Long-Run Growth


 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.
 Hence, budget deficits reduce the economy’s growth rate and future standard of living.

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