CHAPTER

26
Saving, Investment, and the
Financial System
Economics
PRINCIPLES OF

N. Gregory Mankiw

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In this chapter,
look for the answers to these questions:
 What are the main types of financial institutions in
the U.S. economy, 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 govt policies affect saving, investment, and
the interest rate?
2
 Situation I
 Imagine you have just graduated from college (with BBAH
degree) and you have decided to start your own business –an
economic forecasting firm before you make any money selling
your forecasts, you have to incur substantial costs to set up our
business.
 What kind of investment you would require to do?
 If you don’t have money, whom do you approach for finance?

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 3

 Financial Institutions
 The 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:
 The Bond Market.
A bond is a certificate of indebtedness.
 The Stock Market.
A stock is a claim to partial ownership in a firm.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 4

 Financial Institutions
 The financial system: the group of institutions that helps to
match the saving of one person with the investment of another.
 Financial system consists of the institutions that help to match
one person’s saving with another person’s investment.
 Saving and investment are key drivers to long run economic
growth.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 5

 Saving and Investment

 Saving = Investment in capital Country’s

productivity standard of living

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 6

 Composition of Financial Institutions
 It could be broadly divided into two types:
 Financial Intermediaries
 Financial Markets

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 7

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

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 8

 Banks
 If an owner of a small grocery store want to finance an expansion
of his business, he would most likely approach local bank.
 Bank acts as a financial intermediary between the savers and
depositors
 Banks facilitate purchase of goods and services by allowing
people to write check against their deposits and access deposits
with debit cards.
 Banks help create a special asset that people can use as a medium
of exchange.
 Stock and bonds are examples of store of value for the wealth
that people have accumulated.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 9

 Mutual Funds
 An institution that sells shares to the public and issues the
proceeds to buy a portfolio of stocks and bonds.
 If the value of portfolio rises, the shareholder benefits,
otherwise suffers the loss
 People with small amount of money to diversify their holdings
 Invest peoples money in diversified portfolio of stocks and
bonds
 Ordinary people access the skills of professional money
managers
 Index funds

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 10

 Financial Markets
 Financial markets are the institutions through which a person
who wants to save can directly supply fund to a person who
wants to borrow
 Bond market
 Stock Market

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 11

 Bond Market
 Intel wants to borrow to finance construction of a new factor, it
can borrow directly from the public. It does this by selling bonds.
 A bond is a certificate of indebtedness that specifies the
obligations of the borrower to the holder of the bond.
 Date of Maturity
 Maturity period of bond (Short term, few months, 30 years)
 Long term bonds versus short term bonds
 Credit risk (default)
 Tax treatment
 Municipal bonds

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 12

 Stock Market
 Stock represents ownership in a firm, therefore, a
claim to the profit that the firm makes
 The sale of stock to raise money is called equity
finance
 Sale of bond is called debt finance
 Stock index

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 13

 Different Kinds of Saving
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

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 14

 National Saving
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

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 15

 Saving and Investment
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

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 16

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 17
 Private Savings

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 18

 Budget Deficits and Surpluses
Budget surplus
= an excess of tax revenue over govt spending
= T–G
= public saving

Budget deficit
= a shortfall of tax revenue from govt spending
= G–T
= – (public saving)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 19

ACTIVE LEARNING 1
A. Calculations
 Suppose GDP equals $10 trillion,
consumption equals $6.5 trillion,
the government spends $2 trillion
and has a budget deficit of $300 billion.
 Find public saving, taxes, private saving,
national saving, and investment.

20
ACTIVE LEARNING 1
Answers, part A
Given:
Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

Public saving = T – G =

Taxes: T = G – 0.3 =

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

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

Investment = national saving =

21
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

22
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.
23
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.

24
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?

25
 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 do with saving:
 Buy corporate bonds or equities
 Purchase a certificate of deposit at the bank
 Buy shares of a mutual fund
 Accumulate in saving or checking accounts

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 26

 The Meaning of Saving and Investment
 Investment 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.

Remember: In economics, investment is NOT

the purchase of stocks and bonds!
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 27
 The Market for Loanable Funds
 A supply-demand model of the financial system
 Helps us understand
 how the financial system coordinates
saving & investment
 how govt policies and other factors affect
saving, investment, the interest rate

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 28

 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.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 29

 The Market 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.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 30

 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)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 31

 The Market 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.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 32

 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

50 80 Loanable Funds
($billions)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 33

 Equilibrium
The interest rate
Interest adjusts to equate
Rate Supply supply and demand.

The eq’m quantity

5% of L.F. equals
eq’m investment
and eq’m saving.
Demand

60 Loanable Funds
($billions)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 34

 Policy 1: Saving Incentives
Tax incentives for
Interest saving increase
Rate S1 S2 the supply of L.F.

…which reduces the

5%
eq’m interest rate
4%
and increases the
eq’m quantity of L.F.
D1

60 70 Loanable Funds
($billions)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 35

 Policy 2: Investment Incentives
An investment tax
Interest credit increases the
Rate S1 demand for L.F.
6%
…which raises the
5% eq’m interest rate
and increases the
D2 eq’m quantity of L.F.
D1

60 70 Loanable Funds
($billions)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 36

 Government Budget Deficits and Surplus

 Budget deficit: Government spending > Revenue

 Surplus budget: Tax Revenue > Government spending
 Balanced budget: Tax Revenue = Government spending

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 37

 Deficit Budget
 How this would affect the supply of money in the
economy and interest rates?
 What would be its effect on loanable funds/ borrowings?
 How this would effect investment?

 The fall in investment because of government borrowing

is called crowding out

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 38

 Surplus Budget
 How this would affect the supply of money in the
economy and interest rates?
 What would be its effect on loanable funds/ borrowings?
 How this would effect investment?

 https://www.indiabudget.gov.in/expenditure_profile.php
 https://union2019.openbudgetsindia.org/en/

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 39

ACTIVE LEARNING 2
Exercise
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?

40
ACTIVE LEARNING 2
Answers A budget deficit reduces
national saving and the
Interest S2 supply of L.F.
Rate S1

…which increases
6% the eq’m interest rate
5% and decreases the
eq’m quantity of L.F.
and investment.
D1

50 60 Loanable Funds
($billions)
41
 Policy 3: Govt Budget Deficits
A budget deficit reduces
Interest S2 national saving and the
Rate S1
supply of L.F.

6%
…which increases
5%
the eq’m interest rate
and decreases the
eq’m quantity of L.F.
D1

50 60 Loanable Funds
($billions)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 42

 Budget Deficits, Crowding Out,
and Long-Run Growth
 Our analysis: Increase in budget deficit causes
fall in investment.
The govt 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.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 43

 The U.S. Government Debt
 The government finances deficits by borrowing
(selling government bonds).
 Persistent deficits lead to a rising govt debt.
 The ratio of govt debt to GDP is a useful
measure of the government’s indebtedness
relative to its ability to raise tax revenue.
 Historically, the debt-GDP ratio usually rises
during wartime and falls during peacetime – until
the early 1980s.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 44

 U.S. Government Debt
as a Percentage of GDP, 1970-2007
120%
WW2
100%

80%
Revolutionary
60%
War
Civil
WW1
War
40%

20%

0%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
45
 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.
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 46
CHAPTER SUMMARY

 The U.S. 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.

47
CHAPTER SUMMARY

 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.
48