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Government, Business and

Society
Saving Investment and Financial
System

Financial Institutions
• Financial system
– Group of institutions in the economy that help
match one person’s saving with another person’s
investment
– Moves the economy’s scarce resources from
savers to borrowers

• Financial institutions
– Financial markets
– Financial intermediaries
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• Savers can directly provide funds to borrowers • The bond market • The stock market 3 .Financial Markets • Financial markets – Institutions through which a person who wants to save can directly supply funds to a person who want to borrow.

the loan will be repaid • Rate of interest • Principal .certificate of indebtedness (IOU) • Time/ date of maturity .Financial Markets • The bond market – Bond .amount borrowed – Three Characteristics: • Term .length of time until maturity • Credit risk – probability of default • Tax treatment 4 .

Financial Markets • The stock market – Stock .claim to partial ownership in a firm and therefore claim to the profits – Organized stock exchanges • Stock prices: demand and supply – Equity finance • Sale of stock to raise money – Stock index • Average of a group of stock prices 5 .

Financial Intermediaries • Financial intermediaries: financial institutions through which savers can indirectly provide funds to borrowers. – Banks – Mutual funds 6 .

Financial Intermediaries • Banks – Take in deposits from savers • Banks pay interest – Make loans to borrowers • Banks charge interest – Facilitate purchasing of goods and services by • Checks/ debit cards – medium of exchange 7 .

Financial Intermediaries • Mutual funds – Institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds – Advantages • Diversification • Access to professional money managers 8 .

Saving and Investments in National Income Accounts • Rules of national income accounting includes several Important identities. • Identity – An equation that must be true because of the way the variables in the equation are defined – Clarify how different variables are related to one another 9 .

Accounting Identities • Gross domestic product (GDP) – Total income – Total expenditure • Y = C + I + G + NX • • • • • Y= gross domestic product GDP C = consumption I = Investment G = government purchases NX = net exports 10 .

Accounting Identities • Closed economy – Doesn’t interact with other economies – NX = 0 • Open economy – Interact with other economies – NX ≠ 0 11 .

Accounting Identities • Assumption: close economy: NX = 0 • Y=C+I+G • National saving (saving). S • Total income in the economy that remains after paying for consumption and government purchases • Y–C–G=I • S=Y–C-G • S=I 12 .

Y – T – C – Income that households have left after paying for taxes and consumption • Public saving. T – G – Tax revenue that the government has left after paying for its spending 13 .Accounting Identities • T = taxes minus transfer payments • S=Y–C–G • S = (Y – T – C) + (T – G) • Private saving.

Accounting Identities • Budget surplus: T – G > 0 – Excess of tax revenue over government spending • Budget deficit: T – G < 0 – Shortfall of tax revenue from government spending 14 .

Saving and Investing • Accounting identity: S = I • Saving = Investment – For the economy as a whole. • Although the accounting identity S = I shows that saving and investment are equal for the economy as a whole. such as equipment or buildings. 15 . investment refers to the purchase of new capital. saving must be equal to investment. • In the language of macroeconomics. this does not have to be true for every individual household or firm.

The Market for Loanable FundsModel of Financial Markets • Market for loanable funds (Assumptions) – Market • Those who want to save supply funds • Those who want to borrow to invest demand funds • Thus term loanable funds refers to all income that people have chosen to save and lend out – One interest rate • Return to saving • Cost of borrowing – Assumption • Single financial market 16 .

The Market for Loanable Funds • Supply and demand of loanable funds – Source of the supply of loanable funds • Saving – Source of the demand for loanable funds • Investment – Price of a loan = real interest rate (Real) • Borrowers pay for a loan • Lenders receive on their saving 17 .

The Market for Loanable Funds • Supply and demand of loanable funds – As interest rate rises • Quantity demanded declines • Quantity supplied increases – Demand curve • Slopes downward – Supply curve • Slopes upward 18 .

19 . The supply of loanable funds comes from national saving. including both private saving and public saving. and $1.200 Loanable Funds (in billions of dollars) The interest rate in the economy adjusts to balance the supply and demand for loanable funds.200 billion of loanable funds are supplied and demanded. The demand for loanable funds comes from firms and households that want to borrow for purposes of investment. Here the equilibrium interest rate is 5 percent.The Market for Loanable Funds Interest Rate Supply 5% Demand 0 $1.

The Market for Loanable Funds • Government policies – Can affect the economy’s saving and investment • Saving incentives • Investment incentives • Government budget deficits and surpluses 20 .

if a reform of the tax laws encouraged greater saving.Policy 1: Saving Incentives • Shelter some saving from taxation – Affect supply of loanable funds – Increase in supply • Supply curve shifts right – New equilibrium • Lower interest rate • Higher quantity of loanable funds -Greater investment Thus. 21 . the result would be lower interest rates and greater investment.

200 billion to $1. . . As a result. and the equilibrium quantity of loanable funds saved and invested rises from $1. A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S1 to S2. Tax incentives for saving increase the supply of loanable funds .600 billion. . which reduces the equilibrium interest rate 0 . . .Saving Incentives Increase the Supply of Loanable Funds Interest Rate Supply. 5% 4% 2.600 Loanable Funds (in billions of dollars) 3... and the lower interest rate would stimulate investment. . . . Demand $1. and raises the equilibrium quantity of loanable funds.200 $1. S1 S2 1. Here the equilibrium interest rate falls from 5 percent to 4 percent. the equilibrium interest rate would fall. 22 .

if a reform of the tax laws encouraged greater investment.Policy 2: Investment Incentives • Investment tax credit – Affect demand for loanable funds – Increase in demand • Demand curve shifts right – New equilibrium • Higher interest rate • Higher quantity of loanable funds. the result would be higher interest rates and greater saving.Greater saving Thus. 23 .

400 billion.400 (in billions of dollars) 3. An investment tax credit increases the demand for loanable funds . and the higher interest rate would stimulate saving.200 $1. . . the equilibrium interest rate would rise. .Investment Incentives Increase the Demand for Loanable Funds Interest Rate Supply 1. As a result. D1 Loanable Funds $1.. and the equilibrium quantity of loanable funds saved and invested rises from $1. 0 If the passage of an investment tax credit encouraged firms to invest more. and raises the equilibrium quantity of loanable funds. . the demand for loanable funds would increase. . D2 Demand. 24 . . the equilibrium interest rate rises from 5 percent to 6 percent. 6% 5% 2. which raises the equilibrium interest rate . when the demand curve shifts from D1 to D2.200 billion to $1.. . Here. .

starts with balanced budget – Then starts running a budget deficit • Change in supply of loanable funds • Decrease in supply – Supply curve shifts left • New equilibrium – Higher interest rate – Smaller quantity of loanable funds 25 .Policy 3: Budget Deficit/Surplus • Government .

Here. . the resulting budget deficit lowers national saving.The Effect of a Government Budget Deficit Interest Rate S2 6% 1. the equilibrium interest rate rises from 5 to 6 percent. and reduces the equilibrium quantity of loanable funds.200 billion to $800 billion. . S1 Demand Loanable Funds (in billions of dollars) 3. it crowds out households and firms that otherwise would borrow to finance investment. Thus. and the equilibrium interest rate rises. The supply of loanable funds decreases. 5% 2. when the supply shifts from S1 to S2.. and the equilibrium quantity of loanable funds saved and invested falls from $1. A budget deficit decreases the supply of loanable funds . . when the government borrows to finance its budget deficit. 0 $800 $1. 26 . . .200 When the government spends more than it receives in tax revenue. . Supply. . . which raises the equilibrium interest rate ..

Policy 3: Budget Deficit/Surplus • Crowding out – Decrease in investment results from government borrowing • Government .budget deficit – Interest rate rises – Investment falls 27 .

Policy 3: Budget Deficit/Surplus • Government – budget surplus – Increase supply of loanable funds – Reduce interest rate – Stimulates investment 28 .