CHAPTER 26_Saving, Investment, and the Financial System

Financial Institutions

• The financial system helps match one person's saving with another's investment.
• Financial institutions:
  • Financial markets: Savers directly provide funds to borrowers.
  • Financial intermediaries: Savers indirectly provide funds to borrowers.

Financial Markets

• Two key markets:
  • Bond market: Corporations and governments borrow directly from the public by selling bonds.
    • A bond is a certificate of indebtedness.
    • Debt finance.
    • Three characteristics: term, credit risk, and tax treatment.
  • Stock market: Firms raise money by selling ownership in the firm.
    • A stock is a claim to partial ownership in a firm.
    • Equity finance.

Financial Intermediaries

• Banks:
  • Take deposits from savers and use them to provide loans to borrowers.
  • Facilitate purchases by providing access to funds.
• Mutual funds:
  • Sell shares to the public and use the proceeds to buy portfolios of stocks and bonds.
  • Allow people with small amounts of money to diversify their holdings.

Savings and Investment in the National Income Accounts

• National saving (S): Total income in the economy that remains after paying for consumption and government purchases.
• National income accounting identity: $Y = C + I + G + NX$
• Closed economy case: $Y = C + I + G$
• Solve for I: $I = Y – C – G = S$

Savings and Investment in the National Income Accounts

• Private saving: Income households have left after paying for taxes and consumption. $= Y – T – C$
• Public saving: Tax revenue the government has left after paying for its spending. $= T – G$

Savings and Investment in the National Income Accounts

• Budget surplus: An excess of tax revenue over government spending. $= T – G = \text{public saving}$
• Budget deficit: A shortfall of tax revenue from government spending. $= G – T = -(\text{public saving})$

Active Learning 1: Calculations

• Suppose:
  • GDP equals $10 trillion.
  • Consumption equals $6.5 trillion.
  • The government spends $2 trillion.
  • The government has a budget deficit of $300 billion.
• Find public saving, taxes, private saving, national saving, and investment.

Active Learning 1: Answers, part A

• Given: $Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3$
• Public saving $= T – G = – 0.3$
• Taxes: $T = G – 0.3 = 1.7$
• Private saving $= Y – T – C = 10 – 1.7 – 6.5 = 1.8$
• National saving $= Y – C – G = 10 – 6.5 – 2 = 1.5$
• Investment $= \text{national saving} = 1.5$

Active Learning 1: How a tax cut affects saving

• Use the numbers from the preceding exercise, but suppose now that the government cuts taxes by $200 billion.
• In each of the following two scenarios, determine what happens to public saving, private saving, national saving, and investment.
  1. Consumers save the full proceeds of the tax cut.
  2. Consumers save 1/4 of the tax cut and spend the other 3/4.

Active Learning 1: Answers, part B

• In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion.
  1. If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged.
  2. If consumers save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion.

The Meaning of Saving and Investment

• Private saving is the income remaining after households pay their taxes and consumption.
• Households may use this money to:
  • Buy stock or bonds from a corporation.
  • Deposit in the bank.
  • Buy shares of a mutual fund.
• Investment is the purchase of new capital. For example:
  • A firm spends $250 million to build a new factory.
  • You buy $5,000 on computer equipment for your business.
  • Your parents spend $300,000 to have a new house built.

The Market for Loanable Funds

• Market for loanable funds: The market in which those who want to save supply funds, and those who want to borrow to invest demand funds.
• Helps us understand:
  • How the financial system coordinates saving and investment.
  • How government policies and other factors affect saving, investment, and the interest rate.
• Assume only one financial market.

Supply and Demand for Loanable Funds

• The supply of loanable funds comes from saving:
  • Households with extra income can loan it out and earn interest.
  • Public saving, if positive, adds to national saving and the supply of loanable funds. If negative, it reduces national saving and the supply of loanable funds.
• The demand for loanable funds comes from investment:
  • Firms borrow the funds they need to pay for new equipment and factories.
  • Households borrow the funds they need to purchase new houses.

The Market for Loanable Funds

• An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.

Policy 1: Saving Incentives

• Tax incentives for saving increase the supply of loanable funds.

Policy 2: Investment Incentives

• Tax incentives for investments increase the demand of loanable funds.

Active Learning 2: Budget deficits

• Use the loanable funds model to analyze the effects of a government budget deficit.
  • Draw the diagram showing the initial equilibrium.
  • Determine which curve shifts when the government runs a budget deficit.
  • Draw the new curve on your diagram.
  • What happens to the equilibrium values of the interest rate and investment?

Policy 3: Government Budget Deficits and Surpluses

• A budget deficit lowers national savings.
• An increase in budget deficit causes fall in investment and a rise in the interest rate.
• If the government borrows to finance its deficit, it leaves fewer funds available for investment by households and firms. This is called crowding out.
• A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Summary

• The financial system comprises various financial institutions like stock and bond markets, banks, and mutual funds.
• National saving equals private saving plus public saving.
• In a closed economy, national saving equals investment.
• The supply of loanable funds comes from saving. The demand for funds comes from investment. The interest rate adjusts to balance supply and demand in the loanable funds market.
• A government budget deficit is negative public saving, so it reduces national saving, the supply of funds available to finance investment.
• When a budget deficit crowds out investment, it reduces the growth of productivity and GDP.