Chapter 4 Saving, investment and

financial system
Mentor Pham Xuan Truong
[email protected]
Content
I Financial system in the economy
II Saving and investment in National Income Account
III The market for loanable funds
 I Financial system in the economy
 Financial system: Group of institutions in the economy
that help match one person’s saving with another person’s
investment
Indirect channel

Capital Financial intermediary Capital

Financial system
Lenders Borrowers
- Households - Households
- Firms - Firms
- Government Capital Financial market Capital - Government
- Foreign entities - Foreign entities

Direct channel
 I Financial system in the economy
+ Direct channel: Financial markets where savers can directly
provide funds to borrowers
+ Indirect channel: Financial intermediaries where savers can
indirectly provide funds to borrowers

Why we need indirect channel

- Decreasing transaction cost
- Decreasing cost derived from asymmetric information
- Avoiding free driver issue
 I Financial system in the economy
 Financial institutions
+ Direct channel:
i) The bond market
- Bond is the certificate of indebtedness
- Firms raise money by selling bond (loan finance)
- Properties of bond: Time of maturity - at which the loan will be
repaid; Rate of interest; Principal - amount borrowed; Term -
length of time until maturity
- Interest rate of bond depends on Credit risk of borrowers and
term length
- Bond interest and its price: negative relationship (apply: how tax
treatment affects bond interest)
I Financial system in the economy
 Financial institutions
+ Direct channel:
ii) The stock market
- Stock is the claim to partial ownership in a firm
- Firms raise money by selling stock (equity finance)
- Stock is traded in organized stock exchanges
- Stock index is an average of a group of stock prices, which
sensitively indicates market conditions
- Stock prices: demand and supply principle
…
 I Financial system in the economy
 Financial Institutions
+ Indirect channel:
i) Banks:
- Take in deposits from savers (banks pay interest) and make loans
to borrowers (banks charge interest)
- Facilitate purchasing of goods and services by creating
Checks/ATM card – medium of exchange
ii) Mutual funds:
- Institution that sells shares to the public
- Uses the proceeds to buy a portfolio of stocks and bonds
- Advantages: Diversification and Access to professional money
managers. Disadvantages: Moderate profit and Asymmetric
information
…
 II Saving and investment in National
Income Account
Some important identities
 Gross domestic product (GDP) or (Y) represents Total income
and Total expenditure as well
 As we know Y = C + I + G + NX
 With closed economy NX = 0, with open economy NX ≠ 0
 National saving (S) is the total income in the economy that
remains after paying for consumption and tax (if exist)

 We now consider closed economy: Y = C + I + G

+ S = Y – C – G (by definition), I = Y – C – G (by
national income account) → S = I
+ S = (Y – T – C) + (T – G)
while T = taxes minus transfer payments (net tax)
 II Saving and investment in National
Income Account
Some important identities
 Private saving (Sp),Y – T – C
Income that households have left after paying for taxes and consumption
 Public saving (Sg), T – G
Tax revenue that the government has left after paying for its spending
+ Budget surplus: T – G > 0 (Excess of tax revenue over government
spending)
+ Budget deficit: T – G < 0 (Shortfall of tax revenue from government
spending)
 Therefore Sp + Sg = I or Sp +(T – G) = I
or (Sp – I) + T = G government spending funded by
tax collection and net capital from private sector
 II Saving and investment in National
Income Account
Other identities (for Open economy)
 We now consider open economy Y = C + I + G + NX
 Similarly, we have S = Y – C – G, I + NX = Y – C – G
→ S = I + NX or Sp + Sg = I + NX, Sp + (T – G) = I + (X – M)
or (Sp – I) + (M – X) = G – T budget deficit funded by net
capital from private sector and net foreign inflow
 We also have NX = NFI (net foreign investment) therefore
S = I + NFI or S + NDI = I (NDI net domestic investment = - NFI)
 III The Market for Loanable Funds
What is the market for loanable funds?
It is the market for Those who want to save supply funds and Those who
want to borrow to invest demand fund
Assumptions
 One interest rate that reflects Return to saving and Cost of borrowing
 Single financial market
Building the market: Supply and demand of loanable funds
 Source of the supply of loanable funds: Saving
 Source of the demand for loanable funds: Investment
 Price of a loan = real interest rate
 Borrowers pay for a loan
 Lenders receive on their saving

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 III The Market for Loanable Funds
Building the market: Supply and demand of loanable funds
 As interest rate rises
 Quantity demanded declines
 Quantity supplied increases
 Demand curve
 Slopes downward
 Supply curve
 Slopes upward

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 The market for loanable funds

Interest
Rate Supply

5%

Demand

0 $1,200 Loanable Funds

(in billions of dollars)
The interest rate in the economy adjusts to balance the supply and demand for
loanable funds. The supply of loanable funds comes from national saving, including
both private saving and public saving. The demand for loanable funds comes from
firms and households that want to borrow for purposes of investment. Here the
equilibrium interest rate is 5 percent, and $1,200 billion of loanable funds are supplied
and demanded.
III The Market for Loanable Funds
Policies affecting loanable funds
Policy 1: saving incentives
E.g. Shelter some saving from taxation
 Affect supply of loanable funds
 Increase in supply
 Supply curve shifts right
 New equilibrium
 Lower interest rate
 Higher quantity of loanable funds
 Greater investment

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Saving incentives increase the supply of loanable funds

Interest
Rate Supply, S1
S2

1. Tax incentives for saving

5%
increase the supply of
4% loanable funds . . .
2. . . . Which Demand
reduces the
equilibrium
interest rate . . .
0 $1,200 $1,600 Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium quantity of loanable funds.
A change in the tax laws to encourage Americans to save more would shift the supply of loanable
funds to the right from S1 to S2. As a result, the equilibrium interest rate would fall, and the lower
interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to
4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200
billion to $1,600 billion.
 The Market for Loanable Funds
Policies affecting loanable funds
Policy 2: investment incentives
E.g. Investment tax credit
 Affect demand for loanable funds
 Increase in demand
 Demand curve shifts right
 New equilibrium
 Higher interest rate
 Higher quantity of loanable funds
 Greater saving

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 Investment incentives increase the demand for loanable funds

Interest
Rate
Supply

6% 1. An investment tax credit

increases the demand for
5% loanable funds . . .

2. . . . which
raises the D2
equilibrium
interest rate . . . Demand, D1
0 $1,200 $1,400 Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium quantity of loanable funds.
If the passage of an investment tax credit encouraged firms to invest more, the demand for
loanable funds would increase. As a result, the equilibrium interest rate would rise, and the
higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2,
the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of
loanable funds saved and invested rises from $1,200 billion to $1,400 billion.
 The Market for Loanable Funds
Policies affecting loanable funds
Policy 3: government budget deficits and surpluses
Government - starts with balanced budget
E.g. Then starts running a budget deficit by increasing
spending or decreasing tax
 Change in supply of loanable funds
 Decrease in supply
 Supply curve shifts left
 New equilibrium
 Higher interest rate
 Smaller quantity of loanable funds
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 The effect of a government budget deficit

Interest S2
Rate Supply, S1

6%
1. A budget deficit decreases
the supply of loanable funds . .
5% .
2. . . . which
raises the
equilibrium Demand
interest rate . . .

0 $800 $1,200 Loanable Funds

(in billions of dollars)
3. . . . and reduces the equilibrium quantity of loanable funds.
When the government spends more than it receives in tax revenue, the resulting budget deficit
lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate
rises. Thus, when the government borrows to finance its budget deficit, it crowds out households
and firms that otherwise would borrow to finance investment. Here, when the supply shifts from
S1 to S2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium
quantity of loanable funds saved and invested falls from $1,200 billion to $800 billion.
 III The Market for Loanable Funds
Policies affecting loanable funds
Policy 3: government budget deficits and surpluses
 Government - budget deficit
 Interest rate rises
 Investment falls
 Crowding out effect
 Decrease in investment
 Results from government borrowing

(Analyze the situation when government runs budget surplus)

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Key concepts
- Financial system
- Financial market
- Financial intermediary
- Bond market, stock market
- Investment saving identity
- Loanable fund market
- Budget deficit, budget balance, budget surplus
- Crowding – out effect