ECO121- MACROECONOMICS

Chapter 26: Savings & Investment

Taught by Que Anh Nguyen - FPT School of Business (FSB)

Original Slides by Ron Cronovich

Based on: N. Gregory Mankiw, Principles of Economics (6ed)

OBJECTIVES

1. What are the main types of financial institutions in the U.S. economy, and what is
their function?

2. What are the three kinds of saving?

3. What’s the difference between saving and investment?

4. How does the financial system coordinate saving and investment?

5. How do govt policies affect saving, investment, and the interest rate?
1. Financial Institutions In The U.S. Economy
1.1. Financial Markets
Financial system:
▪ Group of institutions that helps match the saving of one person with the
investment of another.
▪ Moves the economy’s scarce resources from savers to borrowers
Financial institutions
▪ Financial markets
▪ Financial intermediaries

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1. Financial Institutions In The U.S. Economy
1.1. Financial Markets
Financial markets: institutions through which savers can directly provide funds to
borrowers.
1. The Bond Market.
▪ A bond is a certificate of indebtedness that specifies the obligations of the borrower to
the buyer of the bond.
▪ A bond buyer is a lender, and a bond is an IOU.
▪ Characteristics of a bond included: (1) Date of maturity: the time at which the loan will be
repaid. (2) Rate of interest (3) Principal - amount borrowed
▪ Term - length of time until maturity → Long-term bonds are riskier than short-term bonds
▪ Credit risk – probability of default. Higher interest rates are demanded to compensate for
higher risk.
▪ Tax treatment: The interest on most bonds is taxable income, except for municipal bonds
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1. Financial Institutions In The U.S. Economy
1.1. Financial Markets
Financial markets: institutions through which savers can directly provide funds to
borrowers.
2. The Stock Market.
▪ Stock - claim to partial ownership in a firm
▪ 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 (Dow Jones, SP500, VNIndex)

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1. Financial Institutions In The U.S. Economy
1.2. Financial Intermediaries
Financial markets: Savers can indirectly provide funds to borrowers
1. Banks
a. Take in deposits from savers
→ Make loans to borrowers
b. Banks pay interest on deposits
Banks charge interest for lending
→ Difference in interest rates comprises of
bank’s profit
c. Facilitate purchasing of goods and services
→ Checks – medium of exchange
d. Offer a possible store of value
2. Mutual funds
▪ Institution that sells shares to the public
▪ Uses the proceeds to buy a portfolio of
stocks and bonds
▪ A shareholder accepts all the risk and
return associated with the portfolio
→ Advantages
▪ Diversification for small amounts of
money
▪ Access to professional money managers
▪ index funds: buy all the stocks in a given
stock index vs. active trading
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2. Saving & Investment in the National Income Accounts
2.1. Some Important Identities
▪ Rules of national income accounting
- The rules of national income accounting include 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
1. Gross domestic product (GDP)
Total income
Total expenditure Closed economy
▪ Doesn’t interact with other economies
2. Y = C + I + G + NX ▪ NX = 0
•Y= gross domestic product GDP
•C = consumption Open economy
•G = government purchases ▪ Interact with other economies
•NX = net exports ▪ NX ≠ 0
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2. Saving & Investment in the National Income Accounts
2.1. Some Important Identities

Closed economy
▪ Doesn’t interact with other economies
▪ NX = 0

▪ 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

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2. Saving & Investment in the National Income Accounts
2.1. Some Important Identities
Closed economy
▪ Doesn’t interact with other economies
▪ NX = 0

▪ T = taxes minus transfer payments

• S=Y–C–G
• National saving: S = (Y – T – C) + (T – G)
▪ Private saving, Y – T – C
▪ Income that households have left after paying for Budget surplus: T – G > 0
taxes and consumption Excess of tax revenue over government
spending
▪ Public saving, T – G
▪ Tax revenue that the government has left after Budget deficit: T – G < 0
Shortfall of tax revenue from government
paying for its spending
spending
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2. Saving & Investment in the National Income Accounts
2.1. The Meaning of Saving and Investment
▪ Accounting identity: S = I in a closed economy
▪ Saving = Investment
▪ For the economy as a whole
▪ One person’s savings can finance another person’s investment

➢ What mechanisms lie behind this identity?

➢ What coordinates those people who are deciding
how much to save and those people who are
deciding how much to invest?

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2. Saving & Investment in the National Income Accounts
2.1. 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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2. Saving & Investment in the National Income Accounts
2.1. 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!

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ACTIVE LEARNING 1

▪ 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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ACTIVE LEARNING 1- 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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ACTIVE LEARNING 1- B. How a tax cut affects saving

▪ 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.

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ACTIVE LEARNING 1- 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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3. The Market for Loanable Funds

▪ Market for loanable funds: we assume that the economy has only one financial market
▪ Loanable funds: (1) all income that people have chosen to save and lend out, rather than use
for their own consumption, and (2) to the amount that investors have chosen to borrow to fund
new investment projects
▪ Assumptions
- Single financial market includes
▪ Those who want to save supply funds. All savers deposit their saving in this market.
▪ Those who want to borrow to invest demand funds. All borrowers take out loans from this
market.
- One interest rate
▪ Return to saving
▪ Cost of borrowing

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3. The Market for Loanable Funds
3.1. Supply and Demand for Loanable Funds

➢ Source of the supply of loanable funds

▪ 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.
▪ Price of a loan = real interest rate
▪ Borrowers pay for a loan
▪ Lenders receive on their saving

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3. The Market for Loanable Funds
3.1. Supply and Demand for Loanable Funds

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

3%

60 80 Loanable Funds
($billions)
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3. The Market for Loanable Funds
3.1. 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.

Interest A fall in the interest rate reduces the cost of

Rate borrowing, which increases the quantity of
loanable funds demanded.
7%
→ Demand curve slopes downward

4%

Demand

50 80 Loanable Funds
($billions) 21
 3. The Market for Loanable Funds
3.1. Supply and Demand for Loanable Funds
Real interest rate
Equilibrium The interest rate adjusts to
Interest
Rate equate supply and demand.
Supply

The eq’m quantity of L.F.

equals eq’m investment and
5%
eq’m saving.

Demand

60 Loanable Funds
($billions)
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 3. The Market for Loanable Funds
3.2. Policy 1: Saving Incentives
Low rate of saving is partly attributable to tax laws that
discourage saving.
Interest → reforming the tax code to encourage greater saving
Rate S1 (e.g. expand eligibility for special accounts such as
S2 Individual Retirement Accounts; reduce tax rates for
dividend)
1. Tax incentives for saving increase the
supply of L.F. at any given interest rate
5%
2. S1 shifts to the right to S2
4%
3. …which reduces the eq’m interest
rate and increases the eq’m quantity
D1 of L.F.

if a reform of the tax laws encouraged

60 70 Loanable Funds greater saving, the result would be lower
($billions) interest rates and greater investment 23
3. The Market for Loanable Funds
3.2. Policy 2: Investment Incentives
Congress passed a tax reform → investment tax credit
on new factory or equipment
Interest
Rate S1
1. Tax credit change the demand for L.F. at
any given interest rate
6%
2. D1 shifts to the right to D2
5%
3. …which increases the eq’m interest rate
and increases the eq’m quantity of L.F.
D2

D1 If a reform of the tax laws encouraged

greater investment, the result would be
higher interest rates and greater saving
60 70 Loanable Funds
($billions)
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ACTIVE LEARNING 2- 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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 ACTIVE LEARNING 2- Exercise

A budget deficit reduces national

saving and the supply of L.F.
Interest S
Rate 2 S
1
…which increases the eq’m
6% interest rate
5%
Budget deficit shifts the S curve rather
than the D curve because the supply of
D LF as the flow of resources available to
1
fund private investment. !!!
50 60 Loanable
Funds
($billions)
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3. The Market for Loanable Funds
3.3. Policy 3: Govt Budget Deficits
A budget deficit reduces national saving and the
Interest S2 supply of L.F.
Rate S1
Governments finance budget deficits by
1. borrowing in the bond market,
6% 2. accumulation of past government borrowing
(government debt)
5%
•National saving: S = (Y – T – C) + (T – G)
A change in the government budget balance represents a
change in public saving and, therefore, in the supply of
D1 loanable funds.
…which increases the eq’m interest rate
50 60 Loanable and decreases the eq’m quantity of L.F.
Funds
($billions) Budget deficit lowers national saving, which
results higher interest rates and lower
investment 27
3. The Market for Loanable Funds
3.3. Policy 3: Govt Budget Deficits

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.
→ budget deficits reduce the economy’s growth rate and future standard of living.

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3. The Market for Loanable Funds
3.4. 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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3. The Market for Loanable Funds
3.4. The U.S. Government Debt

U.S. Government Debt as a Percentage of GDP, 1970-2010

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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.
▪ 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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Homework

HOMEWORK:
- Problem 3, 4, 5, 8 pg. 585
(Mankiw 9th ed)

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