Section 2: Saving, Investment, and the Financial System

Financial System

The system of financial markets and financial intermediaries through which firms acquire funds from households for investment and expansion

Financial Intermediaries

Firms such as banks, mutual funds, pension funds, and insurance companies that borrow funds from savers and lend them to borrowers

Stock

A financial security that represents partial ownership of a firm

Bond

A financial security promising to repay a fixed amount of funds; essentially a loan from a household to a firm

Services the Financial System Provides

Risk sharing, liquidity (the ability to convert investments quickly into cash), and information (security prices aggregate investor beliefs).

Macroeconomic Identity: Savings Equals Investment

In a closed economy, the total value of saving ($S$) must equal the total value of investment ($I$).

Market for Loanable Funds

A conceptual market interaction of borrowers (demand for funds) and lenders (supply of funds) that determines the market real interest rate and the quantity of funds exchanged.

Crowding Out

A decline in private expenditure (investment) as a result of increases in government purchases (running a budget deficit), which reduces the supply of loanable funds and raises the real interest rate.

Effect of a Government Budget Deficit on Loanable Funds

Shifts the supply of loanable funds curve to the left, causing the real interest rate to increase and investment to decrease

Effect of Expected Future Profits on Loanable Funds

Shifts the demand for loanable funds curve to the right, causing both the real interest rate and the level of investment to increase.