Lecture 5: Finance, Savings, and Investment

The loanable funds market is the aggregate of all the individual financial markets.
The funds that finance investment come from three sources:
- Household saving
- Government budget surplus
- Borrowing from the rest of the world

Household income (Y) is spent on consumption (C), saved (S), or paid in net taxes (T).
This yields the identity: $Y = C + S + T$
Income also equals the sum of aggregate expenditure: $Y = C + I + G + X - M$
By subtracting G and X from both sides, investment (I) is financed by:
- Household saving (S)
- Government budget surplus (T - G)
- Borrowing from the rest of the world (M - X)
Therefore: $I = S + (T - G) + (M - X)$
A government budget surplus (T > G) contributes funds to finance investment, while a government budget deficit (T < G) competes with investment for funds.
If the country exports less than it imports (M > X), it borrows from the rest of the world to finance some investment; if exports exceed imports (X > M), it lends abroad and part of national saving finances investment in other countries.
The sum of private saving (S) and government saving (T - G) is called national saving:
- $NS = S + (T - G)$
National saving and foreign borrowing together finance investment.

The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money.
The loanable funds market determines the real interest rate, the quantity of funds loaned, saving, and investment.
Formula (conceptual): $$r ext{ is the real interest rate} \