Saving, Investment and the Financial

System

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 0

In this chapter,
look for the answers to these questions:
▪ What are the main types of financial institutions in
the economy, and what is their function?
▪ What are the types 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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 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.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 2

 The bond vs the stock
▪ The bond is a debt security, under which the issuer owes
the holders a debt and (depending on the terms of
the bond) is obliged to pay them interest (the coupon) or
to repay the principal at a later date, termed the maturity
date
▪ Bond is classified based on the type of issuers: firms and
government
▪ Characteristics of bonds: (i) term, (ii) credit risk, (iii) tax
treatment
▪ Level of returns = f(level of risk) and level of risk = f(
degree of uncertainty)
▪ Credit rating agencies? S&P, Fitch, Moody
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 3
 The stock
▪ The stock: ownership in an enterprise, with a
claim on firm's profits
▪ Stocks - offer shareholders greater risk, but
higher potential for reward
▪ Treatment in default - bondholders at head of
line; stock holders at end of the line
▪ Stock prices - reflect expected profitability P
stock = ƒ (future profits)
▪ Stock index - an average of a group of stocks,
e.g., NASDAQ 100; FTSE100, VNINDEX, VN30
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 Financial Institutions
▪ Financial intermediaries: institutions through
which savers can indirectly provide funds to
borrowers. Examples:
▪ Banks pay depositors interest on their deposits
and charge borrowers a slightly higher interest
on their loans
▪ Mutual funds – institutions that sell shares to
the public and use the proceeds to buy portfolios
of stocks and bonds

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 5

 Different Kinds of Saving
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

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 6

 National 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

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 7

 Saving and Investment
Recall the national income accounting identity:
Y = C + I + G + NX
For the rest of this chapter, focus on the closed
economy case:
Y=C+I+G
national saving
Solve for I:
I = Y–C–G = (Y – T – C) + (T – G)

Saving = investment in a closed economy

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 8

 Budget Deficits and Surpluses
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)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 9

ACTIVE LEARNING 1
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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ACTIVE LEARNING 1
Answers, part A
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

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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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
Answers, part B
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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 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

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 14

 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!
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 15
 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.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 16

 U.S. Government Debt
as a Percentage of GDP, 1970-2007
120%
WW2
100%

80%
Revolutionary
60%
War
Civil
WW1
War
40%

20%

0%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
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 The loanable fund market
▪ The loanable fund market: all savers go to one
market to deposit their savings, and all borrowers
go to it to make loans; in this market, there is one
interest rate (for both borrowers and lenders)
▪ The supply of loanable funds comes from
savings
▪ The demand for loanable funds comes from
households and businesses wishing to make
investments, hence investment is the source of
the demand for loanable funds

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 18

 The loanable fund market (cont)
▪ Interest (real) rate [ir] is the price of a loan [the
amount borrowers pay for a loan and the amount
that lenders receive for the savings]
▪ Because a high interest rate makes borrowing
more expensive, the quantity of loanable funds
demanded falls as the interest rate rises'; and 'a
high interest rate makes saving more attractive,
the quantity of loanable funds supplied rises as
the interest rate rises'
▪ The interest rate serves to apportion or allocate
or ration scarce capital (loanable funds) -
inadequate
SAVING, supply
INVESTMENT, ofFINANCIAL
AND THE loanable funds results in
SYSTEM 19
 The loanable fund market (cont)
▪ The interest rate serves to
apportion or allocate or ration
scarce capital (loanable funds)
- inadequate supply of loanable
funds results in higher interest
rates, encouraging savings and
discourages borrowing for
investment
▪ Interest rate adjustments to
balance supply and demand for
loanable funds, 'it coordinates
the behavior of people (lenders
and borrowers)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 20

 Increase in government spending
r

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 21

 Increase in taxes

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 22

 Increase in government spending
and taxes at the same amount

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 23