CHAPTER Saving, Investment, and the

5 Financial System

Principles of Economics M. ISLEIMEYYEH 1

CH.5 Saving, Investment, and Financial System

Questions to be answered

▪ 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?

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CH.5 Saving, Investment, and Financial System

Financial Institutions
▪ The financial system: the group of institutions that helps match the
saving of one person with the investment of another.
▪ 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.

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CH.5 Saving, Investment, and Financial System

▪ Financial intermediaries: institutions through which savers can

indirectly provide funds to borrowers. Examples:
▪ Banks
▪ Mutual funds – institutions that sell shares to the public and
use the proceeds to buy portfolios of stocks and bonds

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Function of Financial Markets
▪ Channels funds from person or business without investment opportunities (i.e.,
“Lender-Savers”) to one who has them (i.e., “Borrower-Spenders”)

▪ Improves economic efficiency

Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

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Function of Financial Markets
▪ There exist two different forms of exchange in financial markets.
▪ Direct finance
▪ lenders and borrowers meet directly to exchange securities.
▪ Borrowers borrow directly from lenders in financial markets by selling financial instruments
which are claims on the borrower’s future income or assets.
▪ Indirect finance
▪ borrowers and lenders never meet directly, but lenders provide funds to a financial
intermediary such as a bank or others institutions (Mutual funds, money managers, …).
▪ Borrowers borrow indirectly from lenders via financial intermediaries (established to source
both loanable funds and loan opportunities) by issuing financial instruments which are claims
on the borrower’s future income or assets.

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Function of Financial Markets 1. Allows transfers of funds from
person or business without
investment opportunities to one
who has them.
2. Improves economic efficiency

(source: Mishkin, 2015) 7

Function of Financial Intermediaries: Indirect Finance

▪ Indirect finance needed because of:

▪ Transactions costs
▪ Risk sharing
▪ Asymmetric information

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Function of Financial Intermediaries: Indirect Finance
▪ Transaction costs
▪ Economies of scale
1. Financial intermediaries make profits by reducing transactions costs
2. Reduce transactions costs by developing expertise and taking advantage of economies
of scale
▪ Liquidity services
A financial intermediary’s low transaction costs mean that it can provide its customers with
liquidity services, services that make it easier for customers to conduct transactions

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Function of Financial Intermediaries: Indirect Finance
▪ Risk Sharing
1. Create and sell assets with low risk characteristics and then use the funds
to buy assets with more risk (called asset transformation).
2. Lower risk by helping people to diversify portfolios (diversification)

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Function of Financial Intermediaries: Indirect Finance
▪ Asymmetric Information: Financial intermediaries reduce
▪ Adverse Selection
▪ Moral Hazard

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Function of Financial Intermediaries: Indirect Finance
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcome are ones most likely to seek a
loan
3. Similar problems occur with insurance where unhealthy people want their known medical
problems covered
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making
it more likely that won't pay loan back
3. Again, with insurance, people may engage in risky activities only after being insured
4. Another view is a conflict of interest

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Classification of financial markets
1. Type of financial claim
• Debt markets
• Equity markets
2. Maturity of the claim
• Money market
• Capital markets
3. Issuance:
• Primary market (newly issued)
• Secondary market (previously issued)
4. Time of the transaction:
• Cash market
• Derivatives market (The contract holder buys or sells a financial instrument at
some future time)
5. Organizational structure:
• Auction market /organized Exchange
• Over-the-counter market 13
 Commercial Bank

Savings and Loans Associations (S&L)

Depository
Institutions Mutual Saving Banks

Credit Unions

Specialized Banks

Contractual
Financial
Intermediaries savings Insurance Companies
Institutions
Pension Funds

Finance Companies
Investment
Intermedaries Mutual Funds (Investment Funds)

Money market Mutual Funds 14

CH.5 Saving, Investment, and Financial System

▪ Recall: GDP (denoted Y):

Y = C + I + G + NX
▪ A closed economy is one that does not interact with other
economies.
▪ It does not engage in international trade in goods and services, nor does it
engage in international borrowing and lending (NX = 0).
Y=C+I+G
▪ What this identity can tell us:
Y–C–G=I

Is the total income in the economy that remains after paying for
consumption and government purchases, which is called national saving
or saving. Principles of Economics M. ISLEIMEYYEH 15
CH.5 Saving, Investment, and Financial System

▪ Substituting S for Y – C – G, then

S=I
Saving = Investment

▪ Let T denote the amount that the government collects from households in taxes
minus the amount it pays back to housholds in the form of transfer payments,
e.g., Social Security.
S=Y–C–G

S = (Y – T – C) + (T– G)

Private saving Public saving

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CH.5 Saving, Investment, and Financial System

▪ Private saving
= The portion of households’ income that is not used for consumption or paying taxes
= Y–T–C

▪ Public saving
= Tax revenue less government spending= T – G

▪ 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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CH.5 Saving, Investment, and Financial System

Budget Deficits and Surpluses

▪ Budget surplus
= an excess of tax revenue over government spending
= T–G
= public saving

▪ Budget deficit
= a shortfall of tax revenue from government spending
= G–T
= – (public saving)

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CH.5 Saving, Investment, and Financial System

ACTIVE LEARNING
A. 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.

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

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CH.5 Saving, Investment, and Financial System

A C T I V E L E A R N I N G (Cont.)

▪ Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8

▪ National saving = Y – C – G = 10 – 6.5 = 2 = 1.5

▪ Investment = national saving = 1.5

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CH.5 Saving, Investment, and Financial System

A C T I V E L E A R N I N G (Cont.)

B. 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.
Answers
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
Principles of Economics M. ISLEIMEYYEH 21
fall by $150 billion.
CH.5 Saving, Investment, and Financial System

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

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22
CH.5 Saving, Investment, and Financial System

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 Flint,
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!
Principles of Economics M. ISLEIMEYYEH 23
CH.5 Saving, Investment, and Financial System

The Market for Loanable Funds

▪ The Market for Loanable Funds is 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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CH.5 Saving, Investment, and Financial System

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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CH.5 Saving, Investment, and Financial System

The Market 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 public saving negative, it reduces national saving and the
supply of loanable funds.

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CH.5 Saving, Investment, and Financial System

The Market for Loanable Funds

Interest An increase in the
Rate Supply interest rate makes
saving more attractive,
6% which increases the
quantity of loanable
funds supplied.
3%

60 80 Loanable Funds
($billions)
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CH.5 Saving, Investment, and Financial System

The Market 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.

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CH.5 Saving, Investment, and Financial System

The Market for Loanable Funds

Interest A fall in the interest rate

Rate reduces the cost of
7% borrowing, which increases
the quantity of loanable
funds demanded.
4%

Demand

50 80 Loanable Funds
($billions)
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CH.5 Saving, Investment, and Financial System

The Market for Loanable Funds: Equilibrium

The interest rate adjusts
Interest to equate supply and
Rate Supply demand.

The equilibrium quantity

5% of Loanable Funds
equals equilibrium
investment and
Demand equilibrium saving.

60 Loanable Funds
($billions)
Principles of Economics M. ISLEIMEYYEH 30
CH.5 Saving, Investment, and Financial System

The Market for Loanable Funds

▪ If the interest rate were lower than the equilibrium level,

demand for funds would exceed supply, causing the interest rate to rise.
➔the rise in the rate would make borrowing more costly, and thus would
reduce the demand for funds.
➔The rise in the interest rate would also encourage households to save
more, which would increase the supply of funds.
➔This process would occur until equilibrium was achieved.

▪ If the interest rate were higher than equilibrium, there would be a surplus of
funds. The interest rate would fall to restore equilibrium.

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CH.5 Saving, Investment, and Financial System

The Market for Loanable Funds

Policy 1: Saving Incentives
Tax incentives for
Interest saving increase
Rate S1 S2 the supply of L.F.

…which reduces the

5% equilibrium interest rate
4% and increases the
equilibrium quantity
D1 of L.F.

60 70 Loanable Funds
Principles of Economics
($billions)
M. ISLEIMEYYEH 32
CH.5 Saving, Investment, and Financial System

The Market for Loanable Funds

Policy 2: Investment Incentives An investment tax
Interest
credit increases the
Rate S1 demand for L.F.

6% …which raises the

eq’m interest rate and
5% increases the eq’m
quantity of L.F.
D2
D1

60 70 Loanable Funds
($billions)
33
CH.5 Saving, Investment, andInvestment,
Saving, Financial and
System
the Financial System

Thank you

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