Chapter 26 Saving, Investment, and the Financial System

Nguyen Thi Thuy VINH

Saving, Investment, and

the Financial System

In this chapter,

look for the answers to these questions:

• What are the main types of financial institutions in an
economy, and what is their function?
• What are the three kinds of saving?
• What’s the difference between saving and investment? •
How does the financial system coordinate saving and
investment?
• How do govt policies affect saving, investment, and the
interest rate?

I. Financial System

Financial markets

Saving
Financial System Investment Financial Intermediaries

Financial system consists of those institutions in the

economy that help to match one person’s saving with
another person’s investment.

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Chapter 26 Saving, Investment, and the Financial System
 I. Financial System

1. Financial markets: institutions through which

savers can directly provide funds to borrowers.

Examples:
– The Bond Market.
A bond is a certificate of indebtedness.
– The Stock Market.
A stock is a claim to partial ownership in a firm.
Firm sales stock to raise money => equity finance
Firm sales bond to raise money => debt finance

⮚ Bond Market
Bond is a certificate of indebtedness that specifies the
obligations of the borrower to the holder of the bond
(IOU)

✔ Face Value (principal value): the principal or the

original amount to be paid by the borrower
✔ Issue Price: price at which investor buy the bond
when they are first issued (these are almost the same
as the principal amount)

⮚ Bond Market

✔ Maturity Date: the time at which the loan will be

repaid (British government issued some bonds
never matures called Perpetual bond or Perpetuity
or Perp)
✔ Term: the length of time until the bond matures
(short-term, medium term and long term)
✔ Coupon: interest rate that the issuer pays to the
bond holder (usually this rate is fixed )

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Chapter 26 Saving, Investment, and the Financial System

⮚ Bond Market
  Characteristics

✔ Term: the long-term bonds are riskier than short

term bonds => paid higher interest rate

✔ Tax treatment : the way in which the tax laws treat

the interest earned on the bond
The interest on most bonds is taxable income
however government and municipal bonds are often
exempt from income tax

⮚ Bond Market

✔ Credit risk: the probability that the borrower will fail

to pay some of the interest or principal or both. A
failure to pay is called a default
A higher interest rate is paid for higher credit risk
bonds
S&P rates the credit risk => Bond ratings
 Investment grade ( ≥ BBB)
 Speculative grade => junk bond (≤ C)

⮚ Stock Market
Stock represents ownership in a firm and is a claim to the
profit that the firm make.
Stocks is higher risk and potentially higher return than
bonds
✔Price of stocks are determined by supply and demand
for stocks in stock market
Demand for a stock reflects people’s perception of the
firm’s future profitability

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Chapter 26 Saving, Investment, and the Financial System

⮚ Stock Market
 ✔ Volume: the number of shares were sold
✔ Dividends: amount of profit is paid to stockholders
✔ Price-earning ratio (P/E): price of the stock divided by
the amount of the corporation earned per share over the
past year.
✔ Stock index: is computed as an average of a group of
stock prices => monitor overall level of stock prices.
E.g. Dow Jones index, S&P 500 index, Nikkei index,
VN index, VN Index 30
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 Primary market and secondary market

✔ Primary market (or new issue market-NIM) where the

securities are sold for the first time => issuers receive
money
The process of selling new issues to investors is called underwriting
The case of a new securities issue is called initial public offering (IPO)

✔ Secondary market: where the securities are sold by and

transferred from one investor or speculator to another =>
issuers receive no money

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I. Financial System
2. Financial intermediaries: institutions through
which savers can indirectly provide funds to
borrowers.
Examples:
– Banks : Take in deposits from people who want to
save and use these deposits to make loans to
people who want to borrow
– Mutual funds – institutions that sell shares to the
public and use the proceeds to buy portfolios of
stocks and bonds

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Chapter 26 Saving, Investment, and the Financial System

⮚ Banks
 Take in deposits from people who want to save and use
 these deposits to make loans to people who want to
borrow.
 Provide payment services => facilitate purchase goods
and services
✔ allow people to write checks => medium of exchange
✔ to accumulate saving => store of value

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⮚ Mutual Funds
An institution that sells shares to the public and used
the proceeds to buy a portfolio of stocks and bonds
✔Allow people with small amounts of money to
diversify => less risk
✔ Manager of most mutual funds pay close attention to
the developments and prospects of the companies in
which they buy stock => buy good stocks and sell bad
ones

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When analyzing the macroeconomic role of the financial

system, it is more important keep in mind the similarity
of these institutions than the difference

These financial institutions all serve same goal: connecting

the resources of savers into the hands of borrowers

Assume: only one financial market

The Market for Loanable Funds

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Chapter 26 Saving, Investment, and the Financial System

II. Some Important Identities

Identity is an equation that must be true because of the
way the variables in the equation are defined .
 1. In the simple economy
Y is output of economy : income and expenditure
Y ≡ C + I and Y ≡ C + S => I ≡ Y- C ≡ S => I ≡ S
In simple economy investment is identically equal to
saving

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2. In closed economy
⬥ Three Kinds of Saving
Private saving = (Y – T) – C
Public saving = T – G
Budget surplus
= an excess of tax revenue over govt spending
= T – G = public saving
Budget deficit
= a shortfall of tax revenue from govt spending
= G – T = – (public saving)

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2. In closed economy
⬥ Three Kinds of Saving

National saving
= private saving + public saving
= (Y – T – C) + (T – G)
=Y–C–G
= the portion of national income that is not used
for consumption or government purchases

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Chapter 26 Saving, Investment, and the Financial System

2. In closed economy
⬥ National income accounting identity:
Y = C + I + G + NX
In closed economy:
Y=C+I+G
Solve for I: national saving

I = Y – C – G = (Y – T – C) + (T – G)

Investment
= Saving in a closed economy Note: It does not have to be true
for every individual household or firm

NOW YOU TRY:

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

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NOW YOU TRY:

B. 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.

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Chapter 26 Saving, Investment, and the Financial System

NOW YOU TRY:

C. Discussion questions

The two scenarios from this exercise were:

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.
• Which of these two scenarios do you think is more
realistic?
• Why is this question important?

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Note: The Meaning of Saving and Investment

• Private saving is the income remaining after

households pay their taxes and pay for consumption. •
Examples of what households do with saving: – Buy
corporate bonds or equities
– Purchase a certificate of deposit at the bank
– Buy shares of a mutual fund
– Let accumulate in saving or checking accounts

Note: The Meaning of Saving and Investment

• Investment is the purchase of new capital.

• Examples of investment:
– General Motors spends $250 million to build
a new factory in Michigan.
– You buy $5000 worth of computer equipment for your
business.
– Your parents spend $300,000 to have a new house

built.

Remember: In economics, investment is NOT the

purchase of stocks and bonds!

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Chapter 26 Saving, Investment, and the Financial System

III. The Market for Loanable Funds

Assume: only one financial market

 – All savers deposit their saving in this market. –
All borrowers take out loans from this market.
– There is one interest rate, which is both the return to
saving and the cost of borrowing.

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III. The Market for Loanable Funds

• A supply-demand model of the financial system •

Helps us understand
- how the financial system coordinates saving &
investment
- how govt policies and other factors affect saving,
investment, the interest rate

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III. The Market for Loanable Funds

1. Supply and Demand for loanable funds

The Supply of loanable funds comes from Saving: -

Private 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 ⇨ reduces national saving and the supply
of loanable funds.

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Chapter 26 Saving, Investment, and the Financial System

III. The Market for Loanable Funds

1. Supply and Demand for loanable funds

The Demand for loanable funds comes from Investment:

 - Firms borrow the funds they need to pay for new
equipment, factories, etc.
- Households borrow the funds they need to purchase
new houses.

III. The Market for Loanable Funds

1. Supply and Demand for loanable funds

Price of loan: represents the amount that borrowers pay

for loans and the amount that lenders receive on their
saving
=> interest rate ( r)
Note: The interest rate in the market for loanable funds
is the real interest rate.

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Present Value: The Time Value of Money

• To compare a sums from different times, we use the

concept of present value.
• The Present Value of a future sum: the amount that
would be needed today to yield that future sum at
prevailing interest rates
• Related concept:
The Future Value of a sum: the amount the sum will be
worth at a given future date, when allowed to earn
interest at the prevailing rate

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Chapter 26 Saving, Investment, and the Financial System

Present Value: The Time Value of Money

Higher interest rate

→ higher future value of saving
 → higher future consumption
→ saving more attractive

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Present Value: The Time Value of Money

Higher interest rate

→ lower present value of future benefit
→ lower profitable from investment
→ lower demand for investment

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III. The Market for Loanable Funds

1. Supply and demand for loanable funds

✔ Higher r → saving more attractive → higher

quantity of loanable funds supplied
⇨ supply curve slopes upward.
✔ Higher r → borrowing more expensive → lower
quantity of loanable funds demanded
⇨ demand curve slopes downward

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Chapter 26 Saving, Investment, and the Financial System

Interest The Slope of the Supply Curve An increase in the

Rate 6% 3%
 Supply increases the quantity of loanable funds
interest rate supplied.
makes saving more attractive, which
60 80 Loanable Funds ($billions)

Interest Rate A fall in the interest rate

The Slope of the Demand Curve reduces the cost of
borrowing, which
7% 4%

increases the quantity of loanable funds

demanded.

Demand

50 80
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Loanable Funds ($billions)

Interest Rate The eq’m quantity

of L.F. equals eq’m
investment and
5% 60 eq’m saving.
Equilibrium Demand

The interest rate

Loanable Funds
adjusts to equate ($billions)
Supply supply and demand.

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Chapter 26 Saving, Investment, and the Financial System

Supply and Demand for Loanable Funds •

Financial markets work much like other markets in
the economy.
The equilibrium of the supply and demand for
loanable funds determines the real interest rate.
 To examine various government policies that
affect saving and investment

2. Government Policies
✔Taxes and saving
✔ Taxes and investment
✔ Government budget deficits

2. Government Policies

Policy 1: Saving Incentive

• Taxes on interest income substantially reduce the

future payoff from current saving and, as a result,
reduce the incentive to save.

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Chapter 26 Saving, Investment, and the Financial System

Interest Rate

5%
Policy 1: Saving Incentive S1
 2. Government Policies
D1 Policy 2: Investment Incentive
Loanable Funds ($billions)
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Suppose that government give a tax reduction to any

firm building a new factory
⇒ Investment tax credit => reward firms that invest in
new capital

⮚ An investment tax credit increases the incentive

to borrow.

Policy 2: Investment Incentive

Interest Rate Loanable Funds ($billions)

5%

S1

60
D1

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Chapter 26 Saving, Investment, and the Financial System

NOW YOU TRY:

Exercise
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?

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Policy 3:Government budget deficits or surplus

• A budget deficit decreases the supply of loanable

funds.
- Shifts the supply curve to the left.
- Increases the equilibrium interest rate.
-Reduces the equilibrium quantity of loanable funds. •
This fall in investment is referred to as crowding out.
- The deficit borrowing crowds out private borrowers
who are trying to finance investments.

Policy 3: Government Budget Deficits and

Surpluses
• A budget surplus increases the supply of loanable
funds, reduces the interest rate, and stimulates
investment.

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Chapter 26 Saving, Investment, and the Financial System

Budget Deficits, Crowding Out,

and Long-Run Growth
• Our analysis: Increase in budget deficit causes
fall in investment.
The govt borrows to finance its deficit,
leaving less funds available for investment. •
This is called crowding out.
• Recall from the preceding chapter: Investment is
important for long-run economic growth. Hence,
budget deficits reduce the economy’s growth rate
 and future standard of living.
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The U.S. Government Debt

• The government finances deficits by borrowing

(selling government bonds).
• Persistent deficits lead to a rising govt debt. • The ratio
of govt debt to GDP is a useful measure of the
government’s indebtedness relative to its ability to raise
tax revenue.
• Historically, the debt-GDP ratio usually rises during
wartime and falls during peacetime – until the early
1980s.

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U.S. Government Debt

as a Percentage of GDP, 1970-2007
120%
WW2
100%

80% 60% 40% 20% 0% Civil

Revolutionary War WW1

War

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 48

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Chapter 26 Saving, Investment, and the Financial System

CONCLUSION
• Like many other markets, financial markets are governed by
the forces of supply and demand.
• One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
Financial markets help allocate the economy’s scarce
resources to their most efficient uses.
• Financial markets also link the present to the future: They
enable savers to convert current income into future
purchasing power, and borrowers to acquire capital to
produce goods and services in the future.
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 CHAPTER SUMMARY

• The U.S. financial system is made up of many types

of financial institutions, like the 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 financial system makes this happen.

CHAPTER SUMMARY

• 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.

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