CHAPTER

26

Savings, Investment
and
Financial System

© 2009 South-Western, a part of Cengage Learning, all rights reserved

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 2
Financial Intermediaries
Financial intermediaries are financial
institutions through which savers can
indirectly provide funds to borrowers.

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 3
Financial Intermediaries
Banks
take deposits from people who want to
save and use the deposits to make loans to
people who want to borrow.
pay depositors interest on their deposits
and charge borrowers slightly higher
interest on their loans.

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 4
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

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FINANCIAL SYSTEM 5
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

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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
Saving == investment
investment in
in aa closed
closed
economy
economy
SAVING, INVESTMENT, AND THE
FINANCIAL SYSTEM 7
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 8
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.

9
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
10
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
◦ Let accumulate in saving or checking accounts

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 11
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:
Remember: In In economics,
economics,
investment
investment is
is NOT
NOT the
the purchase
purchase of
of
stocks
stocks and
and bonds!
bonds!
SAVING, INVESTMENT, AND THE
FINANCIAL SYSTEM 12
THE MARKET FOR LOANABLE
FUNDS
Financial markets coordinate the
economy’s saving and investment in the
market for loanable funds.

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 13
THE MARKET FOR LOANABLE
FUNDS
The market for loanable funds is the
market in which those who want to save
supply funds and those who want to
borrow to invest demand funds.
Loanable funds refers to all income that
people have chosen to save and lend out,
rather than use for their own consumption

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 14
Supply and Demand for Loanable
Funds
The supply of loanable funds comes from
people who have extra income they want
to save and lend out.
The demand for loanable funds comes
from households and firms that wish to
borrow to make investments.

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 15
Supply and Demand for Loanable
Funds
The interest rate is the price of the loan.
It represents the amount that borrowers
pay for loans and the amount that lenders
receive on their saving.
The interest rate in the market for
loanable funds is the real interest rate.

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FINANCIAL SYSTEM 16
Supply and Demand for Loanable
Funds
The interest rate is the price of the loan.
It represents the amount that borrowers
pay for loans and the amount that lenders
receive on their saving.
The interest rate in the market for
loanable funds is the real interest rate.

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 17
Supply and Demand for Loanable
Funds
Financial markets work much like other
markets in the economy.
The equilibrium of the supply and
demand for loanable funds determines the
real interest rate

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FINANCIAL SYSTEM 18
Policy 1: Saving Incentives
Taxes on interest income substantially
reduce the future payoff from current
saving and, as a result, reduce the
incentive to save
A tax decrease increases the incentive for
households to save at any given interest
rate.
The supply of loanable funds curve shifts
to the right.
SAVING, INVESTMENT, AND THE
FINANCIAL SYSTEM 19
Policy 1: Saving Incentives
The equilibrium interest rate decreases.
The quantity demanded for loanable
funds increases.
If a change in tax law encourages greater
saving, the result will be lower interest
rates and greater investment.

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 20
Policy 2: Investment Incentives
An investment tax credit increases the
incentive to borrow.
Increases the demand for loanable funds.
Shifts the demand curve to the right.
Results in a higher interest rate and a
greater quantity saved.
If a change in tax laws encourages greater
investment, the result will be higher
interest rates and greater saving.
SAVING, INVESTMENT, AND THE
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Policy 3: Government Budget
Deficits and Surpluses
When the government spends more than it
receives in tax revenues, the short fall is
called the budget deficit.
The accumulation of past budget deficits
is called the government debt.
Government borrowing to finance its
budget deficit reduces the supply of
loanable funds available to finance
investment by households and firms.
SAVING, INVESTMENT, AND THE
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Policy 3: Government Budget
Deficits and Surpluses
This fall in investment is referred to as
crowding out.
The deficit borrowing crowds out private
borrowers who are trying to finance
investments.

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FINANCIAL SYSTEM 23
Policy 3: Government Budget
Deficits and Surpluses
A budget deficit decreases the supply of
loanable funds.
Shifts the supply curve to the left.
Increases the equilibrium interest rate.
Reduces the equilibrium quantity of
loanable funds.
When government reduces national
saving by running a deficit, the interest
rate rises and investment falls.
SAVING, INVESTMENT, AND THE
FINANCIAL SYSTEM 24
Policy 3: Government Budget
Deficits and Surpluses
A budget surplus increases the supply of
loanable funds, reduces the interest rate,
and stimulates investment

SAVING, INVESTMENT, AND THE

FINANCIAL SYSTEM 25