Lecture 2 Notes: Saving, Investment and the Financial System

ECM1953 Principles of Economics — Lecture 2: Saving, Investment and the Financial System

Key questions addressed

• What’s the difference between saving and investment?
• How does the financial system coordinate saving and investment?
• How do government policies affect saving, investment, and the interest rate?

Financial System and Financial Institutions

• Financial system – Group of institutions in the economy that help match the saving of one person with the investment of another
• Financial institutions – Institutions through which savers can directly provide funds to borrowers
  • 1. Financial markets
  • 2. Financial intermediaries
  • 3. (Not listed in the transcript; note that the slide lists three items but only two are shown explicitly)

Some Important Identities – 1

• Gross domestic product (GDP, Y) – Total income = Total expenditure: $Y = C + I + G + NX$
  • C = consumption
  • I = investment
  • G = government purchases
  • NX = net exports
• In a closed economy: NX = 0, so
  $Y = C + I + G,$
  hence
  $I = Y - C - G.$

Some Important Identities – 2

• National saving (saving), S = Y - C - G
  • Total income in the economy that remains after paying for consumption and government purchases
  • By definition:
    $S = Y - C - G$
  • In a closed economy: Saving (S) = Investment (I)
    $S = I.$

Some Important Identities – 3

• Define T = taxes minus transfer payments
• S = (Y - T - C) + (T - G)
  • Private saving = $Y - T - C$ – Income that households have left after paying for taxes and consumption
  • Public saving = $T - G$ – Tax revenue that the government has left after paying for its spending
• National saving (S) = Private saving + Public saving
  $S = ext{Private saving} + ext{Public saving} = (Y - T - C) + (T - G)$
• Equivalently:
  $S = Y - C - G.$

Budget Surplus or Deficit

• Budget surplus: T - G > 0 – Excess of tax revenue over government spending = public saving
• Budget deficit: T - G < 0 – Shortfall of tax revenue from government spending = –(public saving) = $G - T$

Key takeaways and connections

• In a closed economy, there is a direct identity between saving and investment: $S = I.$ This links how much is saved to how much is invested.
• National saving is the sum of private saving and public saving:
  $S = ext{Private saving} + ext{Public saving} = (Y - T - C) + (T - G) = Y - C - G.$
• The budget balance (surplus or deficit) directly affects public saving and hence national saving.
• The market for loanable funds coordinates saving and investment; the interest rate is the price that equilibrates saving supply with investment demand.
• Government policy (through taxes T and purchases G) affects saving, investment, and the interest rate by altering private saving, public saving, and total national saving.
• These identities form the foundation for analyzing how fiscal policy and the financial system interact within the national income accounting framework.