Economics Notes
Savings and Investment Spending
Savings, investment spending, and the financial system are interconnected.
What You Will Learn
Relationship between savings and investment spending.
How the loanable funds market matches savers with borrowers.
Purposes of financial assets: loans, bonds, stocks, and bank deposits.
How financial intermediaries help investors achieve diversification.
Competing views about asset prices and asset market fluctuations.
Matching Up Savings and Investment Spending
Private investment spending is often funded with other people’s money.
Savings-investment spending identity: Savings and investment spending are always equal for the economy as a whole.
Money for investment spending comes from the savings of others.
Savings–Investment Spending Identity in a Closed Economy
GDP equals total spending on domestically produced final goods and services:
C: Consumer spending
I: Investment spending
G: Government purchases of goods and services
X: Exports to other countries
IM: Imports from other countries
In a closed economy (no trade), and , so .
Total income = Total spending.
Income can be spent on consumption (C + G) or saved (S): .
Total income = consumption spending + savings.
Total income = consumption spending + investment spending: .
Putting these equations together:
Subtracting from both sides:
Savings = Investment spending
Money people save is exactly the amount that businesses invest.
Example: A bakery wants to expand and needs $100,000. This money comes from people’s savings deposited in banks.
Savings–Investment Spending Identity: Government and National Savings
Households are not the only savers; the government can save too.
Budget surplus: Excess of tax revenue over government spending.
Budget deficit: Excess of government spending over tax revenue.
Government borrowing: Funds borrowed by federal, state, and local governments.
Budget balance: Difference between tax revenue and government spending.
National savings: Sum of private savings and the budget balance.
Example: An island with 10 families and a government.
Each family saves $1,000 every year (private savings).
The government collects $5,000 in taxes and spends $4,500.
Budget Surplus Example: The government has a budget surplus of $500, adding to national savings.
If families saved $10,000, national savings will be $10,500 ($10,000 + $500).
Budget Deficit Example: If the government spends $5,500 instead, it has a $500 deficit.
The government borrows $500 from financial markets, reducing national savings.
Total Government Revenue and Expenditure (2022-23)
Total government expenditure: 715.9B
Revenue items do not include proceeds from green bonds ($35.1 billion).
Recurrent expenditure: 563.5BS_{Government} = T - TR - GS{National} = S{Government} + S_{Private}S_{National} = IS_{Government}):
The government collects $1,000 in taxes (T = $1,000).
Spends $200 on transfers (TR = $200).
Spends $600 on public services (G = $600S_{Government} = T - TR - G = 1,000 - 200 - 600 = 200
The government saves $200.
Private Savings (S_{Private}):
People in the town save $800 altogether.
National Savings (S_{National}S{National} = S{Government} + S_{Private} = 200 + 800 = 1,000
National savings of the town is $1,000.
Savings-Investment Identity: This $1,000 is used for investment spending by businesses.
Savings–Investment Spending Identity in an Open Economy
In an open economy, goods and money can flow in and out of the country.
Inflows of funds: Foreign savings that finance investment spending in that country.
Example: Italy invests $100 million in India.
Outflows of funds: Domestic savings that finance investment spending in another country.
Example: India invests $40 million in Italy.
Net capital inflow: Total flow of funds into a country minus the total flow of funds out of a country.
Net Capital Inflow = Inflows - Outflows
Example: India has inflows of $100 million and outflows of $40 million.
Net Capital Inflow = 100 - 40 = 60 million.
India has a positive net capital inflow of $60 million.
Savings–Investment Spending Identity in Open Economy
If a country spends more on imports than it earns from exports, it must borrow the difference from foreigners.
NCI = IM - XI = (GDP - C - G) + (IM - X)GDP - C - GI = S{National} + (IM - X) = S{National} + NCI
Investment spending = National savings + Net capital inflow
Example:
GDP: $500 billion
Consumer spending (C): $300 billion
Government spending (G): $100 billion
National Savings: National Savings = GDP - C - G = 500 - 300 - 100 = 100 billion
India imports $200 billion and exports $150 billion.
Net capital inflow (NCI): NCI = IM - X = 200 - 150 = 50 billion
The country is borrowing $50 billion from abroad.
Total investment spending (I): I = National Savings + NCI = 100 + 50 = 150 billion
Investment spending is made up of $100 billion in domestic savings and $50 billion borrowed from foreign investors (NCI).
Savings–Investment Spending Identity in Open Economies
U.S. investment spending was financed by a private savings and positive net capital inflow and partly offset by a government budget deficit.
German investment spending was financed by private savings and a government budget surplus but was offset by a capital outflow.
Practice Question 1
Capital inflow is the net inflow of funds into a country, or the total inflow of foreign funds into a country minus the total outflow of domestic funds to other countries.
Practice Question 2
Suppose a country exports $50 million of goods and imports $60 million.
This country has a positive capital inflow because the country is receiving money from abroad, through borrowing or foreign investment to cover its trade deficit. Imports exceed exports, so it has a positive capital inflow to make up the difference.
A country is not lending funds to foreigners, but rather borrowing from them because of its trade deficit. If the country had more exports than imports (a trade surplus), it could lend to foreigners
The Market for Loanable Funds
Savers and borrowers are usually different people.
Financial markets channel savings to businesses that want to borrow.
Businesses borrow money to grow, and savers earn money by helping them.
Assume there’s one market that brings savers and borrowers together.
The Market for Loanable Funds Part 2
The loanable funds market: Illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders
The price of loans: Nominal interest rate.
High Interest Rate: Borrowing is expensive (fewer loans) and lending profitable (more lending).
Low Interest Rate: Borrowing is cheap (more loans) and lending is less rewarding (less lending).
Present Value
An investment is worth making if it generates a future return greater than the monetary cost today.
Present value: The amount of money needed today to receive a given amount in the future, given the interest rate.
If you need $1,000 in a year and the interest rate is r, how much do you need to put in the bank now (X)?
X × (1 + r) = $1,000X = $1,000 / (1 + r)
Example: A firm has two projects, each yielding $1,000 a year from now.
Project 1 requires borrowing $900.
Project 2 requires borrowing $950.
Which project is worth borrowing money to finance?
Depends on the interest rate.
A 10% interest rate means $1,000 is worth $909 now, so only Project 1 is worth it.
More projects are worth it as the interest rate falls.
Example with Two Projects
Firm has two potential investment projects, each yielding $1,000 a year from now.
Project 1 requires borrowing $900.
Project 2 requires borrowing $950.
The firm must decide which project is worth borrowing money to finance. The answer depends on the interest rate.
Case with a 10% Interest Rate:
X = 1000 / (1 + 0.10) = 909X = 1000/(1 + 0.05) = 952
Now, both projects become worth it because their costs ($900 and $950) are less than $952.
Demand for Loanable Funds
The interest rate measures the opportunity cost of investment spending.
The lower the interest rate, the less attractive it is to put money into the bank.
The lower the interest rate, the more projects firms want to carry out, the higher the quantity of loanable funds demanded.
The higher interest rate, borrowing becomes more expensive, making fewer investment projects worthwhile. This leads to a decrease in the quantity of loanable funds demanded.
Demand curve for loanable funds is downward sloping because lower interest rates lead to more borrowing, while higher interest rates discourage borrowing.
Supply of Loanable Funds
The supply of loanable funds comes from savers—people or entities that choose to save rather than spend their money today.
When savers lend money, they are rewarded with interest, which increases their future purchasing power.
The Supply of Loanable Funds
Loanable funds are supplied by savers.
By saving money today and earning interest, savers are rewarded with higher consumption in the future. More people are willing to forgo current consumption and make a loan to a borrower when the interest rate is higher.
Example:
If the interest rate is low, let’s say 2%, savers might feel like it's not worth delaying their consumption today because the reward is small. So, they’ll supply fewer loanable funds to the market.
But if the interest rate rises to 6%, saving becomes more attractive because the reward is higher. Now, more people are willing to save, and existing savers might increase their savings, leading to an increase in the quantity of loanable funds supplied.
As the interest rate increases, the reward for saving becomes more attractive. This encourages more people to forgo current consumption (spending now) and instead supply their money into the loanable funds market, allowing it to grow over time with interest.
The Equilibrium Interest Rate
The equilibrium interest rate (r^*$$): The interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded.
The market for loanable funds matches up desired savings with desired investment spending.
This match-up is efficient:
Right investments get made: projects with higher payoffs get financed.
Right people do the saving and lending: those who are willing to lend for lower interest rates get to save and lend.
Only projects that are profitable at an interest rate of 8% or higher are funded.
Any project that can yield a return above the 8% interest rate will be funded. If the project's profitability is lower than 8%, it’s not worth borrowing to finance it.
Offers accepted from lenders willing to lend at an interest rate of 8% or less.
Only savers willing to lend their money at or below the interest rate of 8% will participate. Higher rates might discourage borrowers or create an excess supply of funds.
Shifts of the Demand for Loanable Funds
Factors that can cause the demand curve for loanable funds to shift:
Changes in perceived business opportunities
The demand for loanable funds is largely driven by how much businesses want to borrow for investment projects.
During the dot-com bubble of the 1990s, businesses rushed to buy computers which shifted the demand for loanable funds to the right. In 2001, when the dot-com bubble burst, the demand for loanable funds shifted back to the left.
When businesses see new, profitable opportunities, they borrow more, shifting the demand curve right. When those opportunities disappear or become less promising, the demand curve shifts left.
Changes in government borrowing
Governments also borrow money, especially when they run a budget deficit.
For example, in 2009 the U.S. federal government was running a budget deficit in excess of $1.413 trillion.
When the government runs a large deficit, it borrows heavily from the loanable funds market, which increases the demand for loans. This causes the demand curve for loanable funds to shift to the right.
Increase in the Demand for Loanable Funds
When there is an increase in the demand for loanable funds, the demand curve shifts to the right.
After the demand curve shifts to the right, the new equilibrium occurs at the intersection of the new demand curve and the supply curve.
The new equilibrium has a higher interest rate and a higher quantity of loanable funds being borrowed.
Shifts of the Demand for Loanable Funds
Crowding out occurs when a government budget deficit drives up the interest rate and leads to reduced investment spending.
Crowding out may not occur if the economy is depressed. When the economy is depressed, government spending can lead to higher incomes, and these higher incomes lead to increased savings, which will allow the government to borrow without raising interest rates.
Large budget deficits that the U.S. government ran from 2008 to 2013 in the face of a depressed economy caused little if any crowding out.
Shifts of the Supply of Loanable Funds
Factors that can cause the supply curve for loanable funds to shift:
Changes in private savings behavior
If people decide to save more, the supply of loanable funds increases, shifting the supply curve to the right.
On the other hand, if people decide to save less, the supply of loanable funds decreases, shifting the supply curve to the left
Changes in net capital inflows
When foreign investors believe a country is a safe or profitable place to invest, they send more funds to that country, increasing the supply of loanable funds.
On the other hand, if investor confidence declines, capital inflows decrease, and the supply curve shifts left.
Increase in the Supply of Loanable Funds
When there is an increase in the supply of loanable funds, the supply curve shifts to the right
After the supply curve shifts to the right, the new equilibrium is found where the new supply curve intersects with the demand curve.
This new equilibrium interest rate is lower than before, meaning the cost of borrowing has decreased. The quantity of loanable funds available in the market has increased.
Global Market for Loanable Funds
Capital flows from countries with low interest rates to countries with high interest rates. Capital flows raise interest rates where they were low and reduce rates where they were high.
If a country has low interest rates, investors are less interested in keeping their money there because the returns are small. Instead, they will look for countries with higher interest rates to get a better return on their capital.
Investors in low-interest countries will move their money to countries with high interest rates because these countries offer a better return on savings or investments.
When international capital flows are so large that they equalize interest rates across countries, a global loanable funds market arises.
If one country’s interest rate starts to rise, investors will quickly move capital into that country, so the capital flows from countries with low interest rates to countries with high interest rates because investors seek better returns.
Capital Flows in a Two-Country World
With a 6% interest rate in the U.S. and only 2% in Britain, British investors are incentivized to move their capital to the U.S. for higher returns.
This flow of capital causes the supply of loanable funds in the U.S. to increase, while the supply of loanable funds in Britain decreases.
Capital Flows in a Two-Country World
Britain lends to the United States, leading to equalization of interest rates at 4% in both countries. At that rate, the United States borrows more than it lends; the difference is made up by capital inflows from Britain to the United States.
Capital naturally flows from countries with lower interest rates (where returns are lower) to countries with higher interest rates (where returns are higher).
Over time, this capital flow balances the supply and demand for loanable funds in both countries, leading to a single global interest rate (in this case, 4%).
Inflation and Interest Rates
Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate.
Major changes in interest rates have been driven by many factors, including:
Changes in government policy;
Technological innovations that created new investment opportunities.
Most importantly, people’s expectations about future inflation.
Real interest rate = nominal interest rate – inflation rate.
The true cost of borrowing (and payoff to lending) is the real interest rate.
But neither lenders nor borrowers know what inflation will be, so loan contracts specify a nominal interest rate.
All figures are drawn with the vertical axis measuring the nominal interest rate for a given expected future inflation rate.
The Fisher Effect
According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.
Sixty Years of U.S. Interest Rates
Changes in expected future inflation and changes in the expected return on investment spending clearly move interest rates.
Discussion Question
Suppose that expected inflation rises from 3% to 6%.
How will the real interest rate be affected by this change?
How will the nominal interest rate be affected by this change?
What will happen to the equilibrium quantity of loanable funds?
The Financial System
Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets.
A financial asset is a paper claim that entitles the buyer to future income from the seller. For example, when a saver lends funds to a company, the loan is a financial asset sold by the company that entitles the lender (the buyer of the financial asset) to future income from the company.
A household can also invest its current savings or wealth by purchasing a physical asset, a tangible object that can be used to generate future income. Examples: a house or a piece of equipment.
If you get a loan from your local bank, you and the bank are creating a financial asset: your loan.
A loan is a financial asset, owned by the lender. A loan creates a liability, a requirement to pay income in the future.
Because a financial asset is a claim to future income that someone has to pay, it is also someone else’s liability.
Three Tasks of a Financial System
A well-functioning financial system is a critical ingredient in achieving long-run growth because it encourages greater savings and investment spending. It also ensures that savings and investment spending are undertaken efficiently.
Three tasks of a financial system:
Reducing transaction costs
Transaction costs: the expenses of negotiating and executing a deal
Reducing risk
Financial risk: uncertainty about future outcomes that involve financial losses or gains
Most people are risk-averse, and a financial system helps people reduce their exposure to risk.
Diversification: investing in several assets with unrelated, or independent, risks; reduces risk
Providing liquidity
Liquidity: a measure of how quickly an asset can be converted into cash with relatively little loss of value
If it can be converted into cash quickly, it’s liquid; if not, illiquid.
Practice Question 3
Which of the following assets is most liquid?
A checking account balance of $1,000
Practice Question 4
Financial markets provide a means for: reducing risk, reducing transaction costs, and enhancing liquidity for borrowers and lenders.
Types of Financial Assets
Loans
A loan is a lending agreement between an individual lender and an individual borrower.
Making a loan typically involves a lot of transaction costs (costs of negotiating the terms, investigating the borrower’s credit history, etc.). To minimize these costs, corporations and governments often issue bonds.
Bonds
A bond is an IOU issued by a borrower.
The bond’s issuer promises to pay a fixed interest each year and to repay the principal to the bondholder on a particular date.
Default is the risk that the bond issuer will fail to make payments. Bonds with a higher default risk must pay a higher interest rate to attract investors.
Types of Financial Assets
Loan-backed securities
Loan-backed securities are assets created by pooling individual loans and selling shares in that pool (“securitization”).
With many loans packaged together, it can be difficult to assess the quality of the asset.
The bursting of the housing bubble in 2008 led to widespread defaults on supposedly “safe” mortgage-backed securities.
Stocks
Stocks are shares in the ownership of a company.
For example, Microsoft has nearly 8 billion shares; if you buy a share, you are entitled to one eight billionth of the company’s profit.
Owning stocks is riskier than owning bonds.
Financial Intermediaries
Financial intermediary: An institution that transforms the funds it gathers from many individuals into financial assets
Mutual funds
Pension funds and life insurance companies
Banks
Mutual Funds
Owning shares of a company means accepting risk in return for a higher potential reward. Investors can lower their risk by owning a diversified portfolio of stocks.
Building a diversified portfolio can incur high transaction costs (particularly fees paid to stockbrokers). The solution is mutual funds.
Mutual fund: Financial intermediary that builds a stock portfolio and resells shares of this portfolio to individual investors
Pension Funds and Life Insurance Companies
Pension fund: A type of mutual fund that holds assets to provide retirement income to its members
Life insurance company: Sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies
Banks
Bank deposit: A claim on a bank that obliges the bank to give the depositor their cash when demanded
Bank: A financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers who don’t want to use the stock or bond markets
A bank is lending for long periods of time while its depositors could demand their funds back at any time. How can it manage that?
On average, only a small fraction of depositors will want their cash at the same time. So the bank needs to keep only a limited amount of cash on hand to satisfy its depositors.
In addition, individual bank deposits are guaranteed up to $250,000 by the Federal Deposit Insurance Corporation, or FDIC. This reduces the incentive to withdraw funds if there are concerns about the bank.
Corporate Bonds in the U.S. and Euro Area
U.S. companies tend to issue bonds, while European companies rely on bank borrowing.
Why the difference? U.S. businesses are more inclined to take risks. Also, European banks have more money than U.S. banks because Europeans tend to keep more money in banks than Americans.
Financial Fluctuations
The financial system sometimes doesn’t function well and causes instability.
What causes asset price fluctuations?
The demand for stocks
Demand for stocks depends on investors’ expectations about the future stock prices.
It is also affected by the attractiveness of bonds and other substitute assets.
The demand for other assets
The demand for other assets depends on the expected income and expected prices.
Demand for housing, for example, depends on implicit rent (an estimate of the amount that homeowners, in effect, pay to themselves).
Financial Fluctuations
Asset Price Expectations
There are two competing views about asset price expectations:
You look at fundamentals (earnings, for example), you come up with the value, and if the current price is lower, you buy the asset.
The efficient markets hypothesis:
Asset prices reflect all available information.
At any point in time, stock prices are fairly valued. Stock prices are neither overpriced nor underpriced.
Prices are unpredictable—they follow a random walk (the movement of an unpredictable variable).
Many economists regard the efficient market hypothesis as an oversimplification because investors aren’t that rational. Still, economists are very skeptical about anyone claiming that they can outsmart the market.
Financial Fluctuations
Asset Prices and Macroeconomics
How should economists and policymakers deal with the fact that asset prices fluctuate a lot and that these fluctuations affect the economy?
On one side, policymakers are reluctant to assume that the market is wrong—that asset prices are either too high or too low.
On the other side, the past 25 years were marked by two huge asset bubbles:
The dot-com bubble: In the late 1990s the prices of technology stocks soared, then plunged, helping to cause the 2001 recession.
The housing bubble: In 2008, the collapse of the housing market triggered a severe financial crisis followed by a deep recession.
These events have prompted much debate over whether and how to limit financial instability.