Chapter

Saving, Investment, and

the Financial System
 Chapter objectives
• Financial System
• Saving & investment in National Income
Accounts
• The Market for Loanable Funds
• Effects of Government Policies on the Market
for Loanable Funds

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1. Financial System
• Financial system
– Group of institutions in the economy
– That help match
• One person’s saving
• With another person’s investment
• Financial markets
– Financial institutions
• Savers can directly provide funds to borrowers

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1. Financial System
• Financial intermediaries
– Financial institutions
• Savers can indirectly provide funds to borrowers

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2. Saving & Investment in National Income Accounts

• Gross domestic product (GDP)

– Total income
– Total expenditure
• Y = C + I + G + NX
• Y= gross domestic product GDP
• C = consumption
• G = government purchases
• NX = net exports

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2. Saving & Investment in National Income Accounts

• Assumption: closed 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 National Income Accounts

– S = Y – C –G
– S = (Y – T – C) + (T –G)
• Private saving, 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

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2. Saving & Investment in National Income Accounts

• Surplus and Deficit

•If T > G, the government runs a budget
surplus because it receives more money than
it spends.
•If G > T, the government runs a budget
deficit because it spends more money than it
receives in tax revenue

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2. Saving & Investment in National Income Accounts

• The meaning of Saving and Investing

– For the economy as a whole, saving and
investment are equal
– This does not have to be true for every
individual household or firm

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3. The Market for Loanable Funds
• Assumption
– One financial market: The market for loanable funds
» All savers go to this market to deposit their
saving
» All borrowers go to this market to take out their
loans
– One interest rate
» Return to saving
» Cost of borrowing

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3. 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
– Real interest rate adjusts supply of loanable
funds and demand for loanable funds

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3. 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

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Figure 1
The market for loanable funds

Real interest
rate, r Supply, S

r1

Demand, D

Q1 Loanable Funds, Q
(in billions of dollars)

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4. Effects of Government Policies on the Market for
Loanable Funds
• Policy 1: saving incentives
Suppose that Congress passed a tax reform aimed
at encouraging more saving
– Affect supply of loanable funds
– Increase in supply
• Supply curve shifts right
– New equilibrium
• Lower interest rate
• Higher quantity of loanable funds

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Figure 2
Saving incentives increase the supply of loanable funds

Interest
Rate, r Supply, S1
S2

1. Tax incentives for saving

r1
increase the supply of
r2 loanable funds . . .
2. . . . Which Demand,D
reduces the
equilibrium
interest rate . . .
Q1 Q2 Loanable Funds, Q
(in billions of dollars)
3. . . . and raises the equilibrium quantity of loanable funds.

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4. Effects of Government Policies on the Market for
Loanable Funds
• Policy 2: investment incentives
Suppose that Congress passed a tax reform aimed
at making investment more attractive.
– Affect demand for loanable funds
– Increase in demand
• Demand curve shifts right
– New equilibrium
• Higher interest rate
• Higher quantity of loanable funds

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 Figure 3
Investment incentives increase the demand for
loanable funds
Interest
Rate, r
Supply, S

r2 1. An investment tax credit

increases the demand for
r1 loanable funds . . .

2. . . . which
raises the D2
equilibrium
interest rate . . . Demand, D1
Q1 Q2 Loanable Funds, Q
(in billions of dollars)
3. . . . and raises the equilibrium quantity of loanable funds.

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4.Impacts of Government Policies on the Market for
Loanable Funds
• Policy 3: government budget deficits and
surpluses
• Government - starts with balanced budget (T=G)
– Then starts running a budget deficit (T<G)
• Change in supply of loanable funds
• Decrease in supply
– Supply curve shifts left
• New equilibrium
– Higher interest rate
– Smaller quantity of loanable funds

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Figure 4
The effect of a government budget deficit
Interest S2
Rate, r Supply, S1

r2
1. A budget deficit decreases
the supply of loanable funds . .
r1 .
2. . . . which
raises the
equilibrium Demand, D
interest rate . . .

Q2 Q1 Loanable Funds, Q
(in billions of dollars)
3. . . . and reduces the equilibrium quantity of loanable funds.

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4. Effects of Government Policies on the Market for
Loanable Funds
• Policy 3: government budget deficits and
surpluses
• Government - start with balanced budget (T=G)
– Then starts running a budget surplus (T > G)
• Change in supply of loanable funds
• ...................... in supply
– Supply curve shifts ..............
• New equilibrium
– .............. interest rate
– ...............quantity of loanable funds

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Figure 5: The effect of a government budget surplus

Interest
Rate,r Supply, S1

r1

Demand, D

Q1 Loanable Funds, Q
(in billions of dollars)

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