Chapter 26: Saving, Investment, and the Financial System

What is the financial system?

the group of institutions that helps match the saving of one person with the investment of another

What are financial markets?

institutions through which savers can directly provide funds to borrowers

What are 2 examples of financial markets?

The bond market

The stock market

What are financial intermediaries?

institutions through which savers can indirectly provide funds to borrowers

What are 2 examples of financial intermediaries?

Banks

Mutual Funds

What are mutual funds?

institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds

What is private saving?

Y - T - C

What is public saving?

T - G

What is national saving?

Private saving + Public saving

Y - C - G

In a closed economy, national savings = what?

Investment

What is a budget surplus?

an excess of tax revenue over govt spending

T - G

+ (public saving)

What is a budget deficit?

a shortfall of tax revenue from govt spending

G - T

- (public saving)

What is investment?

The purchase of new capital

Not the purchase of stocks and bonds!

Is building a new house investment?

Yes

Is building a new factory investment?

Yes

Is buying computer equipment for your business investment?

Yes

What is the market for loanable funds?

A supply-demand model of the financial system

What does the market for loanable funds help us understand?

How the financial system coordinates saving & investment

How government policies and other factors affect saving, investment, and the interest rate

What does the interest rate represent in the loanable funds market?

The return to saving and the cost of borrowing

Where does the supply of loanable funds come from?

Households with extra income loan it out and earn interest

Public saving (if +) adds to the national saving and the supply of loanable funds

An increase in the interest rate does what to saving?

An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.

Where does the demand for loanable funds come from?

Firms borrow the funds they need to pay for new equipment, factories, etc.

Households borrow the funds they need to purchase new houses.

A fall in the interest rate does what to investment?

A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.

What does equilibrium represent in the loanable funds market?

The equilibrium investment and saving

What do tax incentives for saving do to the loanable funds market?

Increase the supply of loanable funds --> reduces the interest rate and increases the quantity of loanable funds

What do investment tax credits do to the loanable funds market?

Increase the demand for loanable funds --> raises the interest rate and increases the quantity of loanable funds

What does a budget deficit do to the loanable funds market?

Shifts the saving curve to the left

How does the crowding out theory happen?

The government runs a budget deficit --> borrows to finance the deficit --> less funds available for investment --> investment falls

How does the government finance deficits?

Borrowing (selling government bonds)