001.07 Savings and Investment Basics

Closed Economy Overview

  • A closed economy is one that does not interact with other economies.

  • In such an economy, total savings (S) must equal total investment (I).

The Loanable Funds Market

  • The loanable funds market is the setting where the savings (S) and investment (I) curves interact.

  • This market determines the long-run real interest rate in an economy.

Example: An Island Economy

  • Visualize a closed classroom as an island economy with no external interactions.

  • All members earn $100 and spend it on food and housing.

    • Investment Scenario:

      • A student wants to invest $150 to start a business but only has $100.

      • They can save $15 per week for 10 weeks to gather enough funds.

      • Total savings equals total investment (S = I).

Mechanics of Investment

  • Savings Method:

    • Students can save until they have needed funds or borrow from classmates.

    • Lending requires promises of future returns (interest).

  • Interest Rates:

    • Interest rate is the compensation lenders require for lending money.

    • Higher interest rates attract more funds to be loaned, influencing supply.

Compound Cases of Financing

  • Case 1: Self-financing through personal savings.

    • Saves $150 and invests the same amount (S = I).

  • Case 2: Total borrowing from others, achieving S = I again.

  • Case 3: A mix of saving and borrowing can also satisfy S = I.

Opening the Economy

  • In an open economy, external borrowing and lending changes the dynamic.

  • The global economy operates as a closed economy (S = I).

Investment Dynamics

  • Investment levels depend on expected future profits.

  • If future earnings are projected to be higher, total investment may increase significantly.

Understanding Savings

  • Savings calculated as:

    • Savings = Income - Spending.

  • Government Savings: Defined as:

    • Government Savings = Government Income - Government Spending.

Aggregate Savings

  • Total private savings (Sp) derives from:

    • Sp = (Y - T) - C.

  • Total savings formula:

    • S = Sp + Sg = (Y - T - C) + (T - G) = Y - C - G.

  • In closed economies, S = I allows the derivation of the identity:

    • Y = C + I + G.

The Role of the Loanable Funds Market

  • Comprises an investment curve (I) and savings curve (S).

  • Long-run real interest rate (r) determined at the intersection of both curves.

Investment Curve Dynamics

  • The investment curve slopes downward (Law of Demand).

    • Higher interest rates reduce demand for loanable funds.

  • Shifts in the investment curve can occur with changes in expected future profits.

Savings Curve Dynamics

  • The savings curve slopes upward (Law of Supply).

    • Higher interest rates enhance the quantity of loanable funds available.

  • Factors influencing the savings curve:

    • Elements such as income (Y) and government savings (Sg).

Summary of Factors Affecting Loanable Funds Market

  1. Government Policies:

    • Budget surplus increases supply, lowering interest rates.

    • Budget deficit decreases supply or increases demand, raising interest rates.

  2. Investment Demand:

    • Business expectations and technology shifts can affect investment demands.

  3. Savings Behavior:

    • Changes in preferences and tax incentives can modify loanable funds supply.