Notes on Saving & Investment

Saving & Investment Overview

Objectives

  • Principal Attributes of Financial Assets:

    • Liquidity: Refers to how easily an asset can be converted into cash without affecting its market price.

    • Rate of Return: The gain or loss made on an investment relative to the amount invested, expressed as a percentage.

    • Risk: The potential financial loss in an investment. Different assets carry varying levels of risk.

  • Bond Pricing and Interest Rates:

    • The price of previously issued bonds inversely relates to interest rates. When interest rates rise, existing bond prices fall and vice versa.

  • Interest Rate Definitions:

    • Nominal Interest Rate: The stated interest rate on a loan or financial product, not adjusting for inflation.

    • Real Interest Rate: The rate adjusted for inflation, indicating the true purchasing power of interest earnings.

  • Interest Rate Relationships:

    • Changes in nominal interest rates affect expected inflation and subsequently real interest rates.

    • Can calculate nominal and real interest rates using the formulas:

    • Nominal interest rate = Real interest rate + Expected inflation.

    • Real interest rate = Nominal interest rate - Expected inflation.

Savings-Investment Spending Identity

  • Simplified Economy Model:

    • No government, imports, or exports.

    • Equations:

    1. Total Income = Total Spending

    2. Total Income = Consumption + Savings

    3. Total Spending = Consumption + Investment

    4. From these, we derive: Savings = Investment

  • Expanded Economic Model Considers:

    1. Government savings (via budget surplus).

    2. Savings not allocated strictly to domestic investment.

Key Financial Terms

  • Budget Surplus: Occurs when tax revenue exceeds government spending.

  • Budget Deficit: Occurs when government spending exceeds tax revenue.

  • Budget Balance (BB): The difference between tax revenue and government spending, can be positive or negative.

  • National Savings: Comprises private savings and the budget balance, representing total savings in the economy.

  • Capital Inflow: The net inflow of funds into a country, representing foreign investment in the domestic economy.

Savings-Investment In an Open Economy

  • Government Impact:

    • Government may save by running a budget surplus (BB > 0) leading to increased investment (I).

    • In contrast, a budget deficit (BB < 0) results in decreased investment (I).

  • Open Economy Implications:

    • Both domestic and foreign entities can save in disparate markets.

    • Net Capital Inflow (CI): Defined as inflow of foreign funds minus domestic outflow.

    • Contributes to investment equations: Private Saving + BB + CI = Investment

    • Positive CI (>0) leads to increasing investment, while Negative CI (<0) leads to decreasing investment.

Financial Interactions

  • Savers and Borrowers Dynamics:

    • Savers: Can be private (individuals/households), public (government), or foreign (international investors).

    • Borrowers: Can also be private, public, or foreign entities.