Economics Chapter Notes on Savings, Investment, and Financial Systems

What You Will Learn in This Chapter

  • Relationship between savings and investment spending.
  • How the loanable funds market connects savers with borrowers.
  • Purposes of four principal types of financial assets: loans, bonds, stocks, and bank deposits.
  • Role of financial intermediaries in achieving diversification for investors.
  • Competing views on asset price determination and implications for macroeconomic stability.

Matching Up Savings and Investment Spending

  • Private investment spending is often funded by others' money.
  • Savings-investment spending identity: Always equal for the economy as a whole.

The Savings-Investment Spending Identity in a Closed Economy

  • GDP formula: GDP = C + I + G.
  • Total income can be directed towards consumer spending (C), government purchases (G), or be saved (S).
    • Alternate expression: GDP = C + G + S.
  • Combined: C + G + S = C + G + I implies S = I (Savings = Investment).

Understanding Savings

  • Government savings:
    • Budget surplus: Tax revenue exceeds government spending.
    • Budget deficit: Government spending exceeds tax revenue.
    • Budget balance: Difference between tax revenue and spending.
    • National savings: Sum of private savings and the budget balance.

The Savings-Investment Spending Identity in an Open Economy

  • Net capital inflow (NCI): Total flow of funds into a country minus funds outflow.
  • Relationship established: I = SNational + NCI for investment spending.

Market for Loanable Funds

  • Loanable funds: A market where savers supply funds and borrowers demand them.
  • Price of loans: Nominal interest rate.
  • Demand for loanable funds: Firms borrow more when interest rates fall, making more projects viable.
Present Value
  • Investment only worthwhile if future returns exceed costs today.
  • Formula: X = Future Value / (1 + r), where X is present value, r is the interest rate.
  • Decision-making depends on interest rates affecting project viability.

The Supply of Loanable Funds

  • Supply curve for loanable funds slopes upward; higher rates encourage more loans.

Equilibrium Interest Rate

  • Equilibrium established where lenders accept offers within a specific interest rate.

Shifts of Demand for Loanable Funds

  • Demand shifts caused by perceived business opportunities and government borrowing changes.

Effects of Government Borrowing

  • Crowding out: High government deficits raise interest rates, reducing private investment, although beneficial in downturns.

Shifts of Supply of Loanable Funds

  • Changes in private savings behavior and net capital inflows can shift supply.

Global Loanable Funds Market

  • International capital flows may equalize interest rates across countries.

Inflation and Interest Rates

  • Shifts in loan supply/demand influence interest rates. Major factors include government policy and inflation expectations.
  • Real interest rate calculation: nominal interest rate minus inflation rate.

The Financial System

  • Essential for managing household wealth and facilitating loans.
  • Wealth: Value of accumulated savings.
  • Financial asset: A claim for future income; Physical asset: Tangible object generating income; Liability: Future payment obligation.

Why a Sound Financial System is Necessary

  • A functioning financial system promotes long-term growth through investment efficiency.

Financial Intermediaries

  • Institutions that transform funds into financial assets, such as mutual funds, pension funds, and banks.

Tasks of a Financial System

  1. Reducing transaction costs: The expenses of negotiating deals.
  2. Reducing risk: Financial risk pertains to uncertainty; Diversification helps mitigate risks.
  3. Providing liquidity: Measure of how quickly assets convert to cash with minimal loss of value.

How Financial Markets Work

  • They reduce risk, transaction costs, and enhance liquidity for borrowers and lenders.

Behavioral Finance

  • Examines how investor psychology results in systematic errors:
    • Overconfidence.
    • Loss aversion.
    • Herd mentality.

The Great American Housing Bubble

  • Economic repercussions of rising home values led to significant market interest and eventual slowdown.