Saving, Investment,

and the Financial

System
SLIDES CREATED BY ERIC CHIANG

CHAPTER

Copyright 2023 Macmillan Learning | Chiang | All rights reserved

11
2 | CHAPTER 11

CHAPTER
OBJECTIVES
• Describe the functions of money.
• Define the money supply according to M1 and M2.
• Demonstrate how savers and borrowers interact in
the loanable funds market.
• Describe the economic factors that lead to a change
in the market for loanable funds.
• Explain how financial intermediaries make it easier
and less risky for people to save and borrow.
3 | CHAPTER 11

CHAPTER
OBJECTIVES
• Describe the relationship between the price of
bonds and their interest rates.
• Explain how the compounding effect makes debt
and savings much larger over time.
• Describe the tradeoff between lower risk and
higher returns, and how that influences the return
on investment for bonds and stocks.
• Explain how retirement savings programs function
and the benefits they provide.
 MONEY IS ANYTHING THAT
IS ACCEPTED IN EXCHANGE
FOR OTHER GOODS AND
SERVICES OR FOR THE
PAYMENT OF DEBT. FOR A
COMMODITY TO BE USED
AS MONEY,
WHAT IS  ITS VALUE MUST BE EASY
MONEY? TO DETERMINE.
 IT MUST BE DIVISIBLE.
 IT MUST BE DURABLE
AND PORTABLE.
 IT MUST BE WIDELY
ACCEPTED BY MANY
FIAT MONEY IS
NOT BACKED
BY A
COMMODITY
SUCH AS
GOLD BUT IS
ACCEPTED AS
MONEY
BECAUSE
GOVERNMENT
HAS MADE IT
LEGAL
TENDER.
 1. MEDIUM OF EXCHANGE:
MONEY IS USED TO
FACILITATE THE
EXCHANGE OF GOODS
AND SERVICES.
THE 2. UNIT OF ACCOUNT:
FUNCTIONS MONEY IS USED TO
COMPARE VALUES OF A
OF MONEY WIDE VARIETY OF
GOODS AND SERVICES.
3. STORE OF VALUE:
MONEY CAN BE SAVED
AND USED FOR FUTURE
PURCHASES.
IN
AUSTRALIA,
ALL
BANKNOTES
ARE MADE
OF PLASTIC,
A MORE
DURABLE
FORM OF
MONEY
THAN PAPER
CURRENCY.
8 | CHAPTER 11

WITHOUT MONEY, THE ALTERNATIVE IS BARTER

BARTER IS THE DIRECT EXCHANGE OF

GOODS AND SERVICES FOR OTHER GOODS
AND SERVICES. IT REQUIRES A DOUBLE
COINCIDENCE OF WANTS: YOU WANT
SOMETHING THAT I HAVE, IN EXCHANGE
FOR SOMETHING THAT YOU HAVE.
BARTER IS USED PRIMARILY IN PRIMITIVE
ECONOMIES.
 AN ASSET’S LIQUIDITY
IS DETERMINED BY
HOW QUICKLY, EASILY,
LIQUIDITY AND RELIABLY IT CAN
BE CONVERTED INTO
CASH.
MONEY IS
HIGHLY
LIQUID
BECAUSE IT
CAN BE
USED
IMMEDIATEL
Y FOR THE
PURCHASE
OF GOODS
AND
SERVICES.
STOCKS,
BONDS, AND
PRECIOUS
METALS ARE
LESS LIQUID
BECAUSE
THEY MUST
FIRST BE
CONVERTED
TO MONEY
BEFORE THEY
CAN BE USED
TO PURCHASE
GOODS AND
HOUSES
AND OTHER
PHYSICAL
ASSETS ARE
THE LEAST
LIQUID
BECAUSE
THEY
REQUIRE
MUCH MORE
EFFORT TO
CONVERT TO
1. Which of the following is a key function of money as a unit of account?
A. Facilitating the exchange of goods and services
B. Comparing the values of different goods and services
C. Storing value for future use
D. Being a physical commodity like gold
2. Why are stocks, bonds, and precious metals considered less liquid than cash?
A. They are not widely accepted as a medium of exchange
B. They cannot be used to compare the value of goods and services
C. They must first be converted into money before being used to purchase
goods and services
D. Their value does not change over time
3. What is one major limitation of a barter system compared to a money-based
economy?
A. Barter systems allow for direct exchanges without a need for value
comparison
B. Barter systems require a "double coincidence of wants" to facilitate trade
C. Barter systems use precious metals as the primary medium of exchange
 THE FEDERAL RESERVE
(FED) USES TWO PRIMARY
MEASURES OF THE MONEY
SUPPLY, M1 AND M2:

M1 = CURRENCY IN
DEFINING CIRCULATION
THE MONEY (BANKNOTES AND
COINS)
SUPPLY + CHECKABLE
DEPOSITS
+ SAVINGS DEPOSITS
+ MONEY MARKET
DEPOSIT ACCOUNTS
  THE TOTAL VALUE OF THE M1
MONEY SUPPLY IS ABOUT $20
TRILLION. IT IS THE MOST
LIQUID PART OF THE MONEY
SUPPLY.
 M1 INCLUDES CURRENCY
AND DEPOSIT ACCOUNTS
M1 MONEY FROM WHICH ONE CAN
WITHDRAW MONEY EASILY.
SUPPLY  IN APRIL 2020, THE FED
REMOVED LIMITS ON HOW
OFTEN DEPOSITORS CAN
ACCESS FUNDS FROM
SAVINGS AND MONEY
MARKET ACCOUNTS, WHICH
GREATLY EXPANDED THE
 M2 IS A BROADER MEASURE
OF THE MONEY SUPPLY. IT
INCLUDES ALL OF M1 AND
NEAR MONIES:
M2 MONEY M2 = M1
+ SMALL-DENOMINATION
SUPPLY (LESS THAN $100,000)
TIME DEPOSITS (CD)
+ SHARES IN RETAIL
MONEY MARKET MUTUAL
FUNDS
  WHY DO PEOPLE SAVE?
 PEOPLE SAVE FOR VARIOUS
REASONS. THE REWARD
FOR SAVING IS INTEREST.
THE  THE SUPPLY OF LOANABLE
FUNDS IS POSITIVELY
MARKET RELATED TO THE INTEREST
RATE.
FOR  WHY DO PEOPLE BORROW?
LOANABLE  PEOPLE BORROW TO BUY
GOODS AND SERVICES OR
FUNDS TO INVEST IN CAPITAL.
 THE DEMAND FOR
LOANABLE FUNDS IS
INVERSELY RELATED TO THE
INTEREST RATE.
A THEME
PARK
PURCHASING
CAPITAL,
SUCH AS A
NEW ROLLER
COASTER,
OFTEN
RELIES ON
THE MARKET
FOR
LOANABLE
FUNDS.
THE
MARKET
FOR
LOANABLE
FUNDS
THE EQUILIBRIUM
INTEREST RATE IS
DETERMINED BY
BORROWERS
(DEMAND) AND
SAVERS (SUPPLY).
 A SHIFT IN THE SUPPLY
CURVE OF LOANABLE FUNDS
OCCURS WHEN A FACTOR
INCREASES OR DECREASES
SHIFTS IN THE COUNTRY’S
WILLINGNESS TO SAVE AT
THE SUPPLY ANY GIVEN INTEREST RATE.
OF THESE FACTORS INCLUDE
THE FOLLOWING:
LOANABLE

FUNDS ECONOMIC OUTLOOK
 INCENTIVES TO SAVE
 INCOME OR ASSET PRICES
 GOVERNMENT DEFICITS
 ANYTHING THAT CHANGES
THE RATE OF RETURN ON
POTENTIAL INVESTMENT
WILL CAUSE THE DEMAND
FOR LOANABLE FUNDS TO
SHIFTS IN CHANGE. THESE CHANGES
THE DEMAND INCLUDE THE FOLLOWING:
FOR  INVESTMENT TAX
LOANABLE INCENTIVES
 TECHNOLOGICAL
FUNDS ADVANCES
 REGULATIONS
 PRODUCT DEMAND
 BUSINESS EXPECTATIONS
THE MARKET
FOR
LOANABLE 5
S0
S1

REAL INTEREST RATE (%)

FUNDS
A SHIFT IN EITHER 4

THE SUPPLY CURVE e

OR DEMAND CURVE 3
FOR LOANABLE
FUNDS WILL CHANGE 2 a
THE INTEREST RATE.
1
AN INCREASE IN THE D0
SUPPLY OF LOANABLE
0
FUNDS REDUCES 100 200 300 400 500 600
LOANABLE FUNDS (BILLIONS)
INTEREST RATES.
THE
FINANCIAL
SYSTEM
HELPS
ALLOCATE
SCARCE
RESOURCES
FROM
SAVERS TO
BORROWER
S.
 FINANCIAL INSTITUTIONS FULFILL
THREE IMPORTANT ROLES THAT
FACILITATE THE FLOW OF FUNDS
WITHIN THE ECONOMY:
1. REDUCING INFORMATION
ROLES OF COSTS: SCREEN AND
FINANCIAL EVALUATE THE CREDIT OF
POTENTIAL BORROWERS.
INSTITUTIO 2. REDUCING TRANSACTION
COSTS: PROVIDE
NS STANDARDIZED FINANCIAL
PRODUCTS.
3. DIVERSIFYING ASSETS TO
REDUCE RISK: POOL FUNDS
FROM MANY SAVERS AND
LEND TO MANY BORROWERS.
FINANCIAL
INTERMEDIARI
ES INCLUDE
BANKS,
MUTUAL
FUNDS, AND
INSURANCE
COMPANIES.
THEY ACQUIRE
FUNDS FROM
SAVERS AND
LEND THEM
TO
BORROWERS.
Question 1:

How do financial institutions contribute to the efficient flow of funds within the economy?
A. By pooling funds from multiple savers and lending to a diversified group of borrowers,
thereby reducing risk exposure for individual savers
B. By eliminating the need for credit evaluations, relying instead on savers to assess borrower
reliability
C. By increasing transaction costs to discourage excessive borrowing and lending activity
D. By acting as intermediaries that directly dictate the allocation of funds across all sectors of
the economy
Question 2:
A sudden increase in the demand for loanable funds is observed in the economy. Which of the
following combinations of factors is most likely responsible for this shift?
A. Stricter regulations, stagnant product demand, and reduced technological innovation
B. Investment tax incentives, technological advances, and positive business expectations
C. Increased consumer savings, decreased investment tax incentives, and reduced product
demand
D. Central bank policies reducing money supply, declining product demand, and stricter
regulations
 MOST LOANABLE FUNDS ARE
IN THE FORM OF BONDS. A
BOND IS A FORM OF DEBT
BOND USED TO FUND A BUSINESS.
BOND CONTRACTS INCLUDE
PRICES AND THE FOLLOWING:
INTEREST  COUPON RATE (INTEREST
RATE OF THE BOND)
RATES  MATURITY DATE
 FACE VALUE OF THE BOND
(THE VALUE AT MATURITY)
BOND PRICES
FLUCTUATE IN
RESPONSE TO
FORCES OF
THE
MARKETPLACE
. BOND
PRICES AND
INTEREST
RATES MOVE
IN OPPOSITE
DIRECTIONS.
 THE ACTUAL PRICE OF A BOND
CHANGES WITH MARKET
INTEREST RATES, WHICH
DETERMINE ITS YIELD, THE
BOND RETURN EARNED OVER THE
PRICES AND LIFE OF THE BOND.

INTEREST
RATES
Price of bond= Coupon Payment /​
Market Interest Rate
30 | CHAPTER 11

BOND
PRICES AND
INTEREST
RATES
Question 1:
Consider a bond issued by XYZ Company with a face value of $1,000 and a coupon rate of 5%, which
pays $50 annually until maturity. Suppose the prevailing interest rates in the market rise from 5% to
6%. Which of the following statements accurately describes the effect of this change on the price of
the bond?
A) The price of the bond will increase because the coupon rate is now higher than the prevailing
interest rate.
B) The price of the bond will decrease because the coupon rate is now lower than the prevailing
interest rate.
C) The price of the bond will remain unchanged because the coupon rate is fixed for the life of the
bond.
D) The price of the bond will increase because the bondholder will receive higher annual coupon
payments.
Question 2:
XYZ Company issues a bond with a face value of $1,000 and a coupon rate of 5%. The bond pays $50
annually in interest payments. If the prevailing market interest rate increases from 5% to 8%, what
would be the new price of the bond, assuming it is a perpetuity bond (i.e., it has no maturity date)?
A) $625
B) $750
C) $1,000
D) $1,250
STOCKS
REPRESENT
OWNERSHIP IN A
COMPANY AND
ENTITLE
OWNERS TO A
SHARE OF
PROFIT
(DIVIDENDS).
SHARES OF
STOCK ARE
TRADED IN
STOCK
EXCHANGES.
33 | CHAPTER 11

THE TRADEOFF BETWEEN LOWER

RISK AND HIGHER RETURNS.

ON AVERAGE, THE RISKIER THE ASSET,

THE GREATER THE RETURN. HOWEVER,
RISKIER ASSETS HAVE A GREATER CHANCE
OF RECEIVING NOTHING IN RETURN.
FINANCIAL
TOOLS FOR
A BETTER
FUTURE
35 | CHAPTER 11

COMPOUND
ING
INTEREST
36 | CHAPTER 11

Year Starting Value 10% Interest Ending Value EFFECT OF

1
2
$1,000.00
1,100.00
$100.00
110.00
$1,100.00
1,210.00
COMPOUNDI
3 1,210.00 121.00 1,331.00 NG
4
5
1,331.00
1,464.10
133.10
146.41
1,464.10
1,610.51
INTEREST
⁞ ⁞ ⁞ ⁞
28 13,109.99 1,311.00 14,420.99
29 14,420.99 1,442.10 15,863.09
30 15,863.09 1,586.31 17,449.40
You borrow $1,000 at an annual interest rate of 10%. If you do not make any
payments for 10 years, how much will you owe at the end of 10 years due to the
power of compounding interest?
A) $1,500
B) $2,593.74
C) $2,700
D) $2,000
Hint: the compound interest formula:
A=P(1+r)t
Where:
•A = Amount owed after interest
•P = Principal
•r = Annual interest rate
•t = Number of years
ELIMINATI
NG HIGH-
INTEREST
CREDIT
CARD
DEBT CAN
RESULT IN
TREMEND
OUS
SAVINGS.
 PARTICIPATI
NG IN
COMPANY
RETIREMEN
T PLANS
CAN LEAD
TO A MORE
COMFORTA
BLE
FUTURE.
Sanford / Agliolo / Getty Images
  SOCIAL SECURITY IS FUNDED BY
THE PAYROLL TAX (FICA).
 TAXES PAID BY CURRENT
WORKERS ARE DISTRIBUTED
TO CURRENT BENEFICIARIES.
 THE TAX IS 12.4% (6.2% PAID
SOCIAL BY EMPLOYEES AND 6.2%
PAID BY EMPLOYERS) BUT IS
SECURIT CAPPED AT A MAXIMUM
ANNUAL AMOUNT.
Y  THE MINIMUM AGE TO COLLECT
IS 62, BUT PAYMENTS INCREASE
IF ONE WAITS TO START
COLLECTING (UP TO AGE 70).
 BENEFITS ARE CALCULATED BY
A FORMULA BASED ON ONE’S
LIFETIME CONTRIBUTIONS.
41 | CHAPTER 11

PENSIONS ARE A MONTHLY PAYMENT

MADE BY AN EMPLOYER TO A
RETIRED EMPLOYEE UNTIL THEY DIE.
THE AMOUNT DEPENDS ON INCOME
EARNED AND THE NUMBER OF YEARS
WORKED.
PENSIONS ARE MUCH LESS COMMON
TODAY THAN A GENERATION AGO.
 TRADITION ROTH
AL IRA IRA
TRADITIO
NAL IRA PRETAX (TAX-
DEFERRED)
AFTER-TAX
CONTRIBUTIO
VERSUS CONTRIBUTI
NS ARE
INVESTED. NO
ONS ARE
ROTH IRA INVESTED.
PENALTY FOR
EARLY
TAXES PAID WITHDRAWAL.
UPON NO TAXES ON
WITHDRAWA EARNINGS.
L.
43 | CHAPTER 11

KEY
CONCEPTS
• money • liquidity • tradeoff between
• fiat money • M1 lower risk and
higher returns
• barter • M2
• teaser rates
• medium of • financial system
exchange • compounding
• financial effect
• unit of account intermediaries
• vesting period
• store of value • return on
investment (ROI) • pensions
44 | CHAPTER 11

A. LOANABLE FUNDS
QUESTION: DECREASE; INTEREST RATES
INCREASE
SUPPOSE THE
GOVERNMENT B. LOANABLE FUNDS
DECREASE; INTEREST RATES

ENCOURAGES GREATER DECREASE

PARTICIPATION IN C. LOANABLE FUNDS

INCREASE; INTEREST RATES
RETIREMENT PLANS. INCREASE

WHAT HAPPENS TO D. LOANABLE FUNDS

LOANABLE FUNDS AND INCREASE; INTEREST RATES
DECREASE

INTEREST RATES? E. LOANABLE FUNDS AND

INTEREST RATES
UNCHANGED
PRACTICE
QUESTION
:
WHAT TYPE OF
PROBLEMS
ARISE FROM
UNCONTROLLE
D PUBLIC DEBT
AND A
BREAKDOWN
OF FINANCIAL
INSTITUTIONS?
46 | CHAPTER 11

A. $200
QUESTION:
IF A BOND HAS A FACE
B. $800
VALUE OF $1,000 AND
PAYS $40 PER YEAR IN
C. $1,250
INTEREST, HOW MUCH
IS THE BOND WORTH
D. $1,400
AFTER INTEREST RATES
INCREASE TO 5%?
E. $2,000
PRACTICE
QUESTION
:
WHY HAVE
MOST
AMERICAN
CONSUMERS
AND FIRMS
REJECTED THE
EVERYDAY USE
OF ONE DOLLAR
COINS?
48 | CHAPTER 11

QUESTION: A. SAVINGS ACCOUNTS

WHICH OF THE
FOLLOWING B. CHECKING ACCOUNTS

ASSETS WILL
LIKELY SHOW C. U.S. TREASURY BONDS
THE GREATEST
INCREASE IN D. BLUE CHIP STOCKS
VALUE OVER
TIME? E. HIGHLY RATED CORPORATE
BONDS
 End of
Chapter
SLIDES CREATED BY ERIC CHIANG

Copyright 2023 Macmillan Learning | Chiang | All rights reserved