CHAPTER:

SAVING, INVESTMENT AND

THE FINANCIAL SYSTEM

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The Importance of Money
Financial Institutions and Markets
• For an economy to grow, it must forgo present
consumption (save) and invest in new capital
assets
• Money contributes to economic development
and growth by stimulating savings and
investing
• Money separates the act of saving from
investing
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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

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 Some Important Identities

• Public Saving
– Public saving is the amount of tax revenue that the
government has left after paying for its spending.
– Public saving = (T – G)

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Some Important Identities
• Denoting saving by S, we get:
S=I
• For a closed economy, saving equals
investment.

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The Meaning of Saving and
Investment
• For the (closed) economy as a whole, saving
must be equal to investment.
S=I
• For economists, investment refers to purchase
of machinery, equipment and buildings. In
everyday language, “investment” is used to
describe purchases of stocks and bonds. For
us, those are acts of saving.

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SAVING AND INVESTMENT IN
THE NATIONAL INCOME
ACCOUNTS
• Recall that GDP is both total income in an
economy and total expenditure on the
economy’s output of goods and services:
Y = C + I + G + NX

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Some Important Identities
• Assume a closed economy (as opposed to an
open economy). A closed economy does not
engage in international trade: NX = 0
Y=C+I+G

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Some Important Identities
• We define national saving of an economy as the
total income in the economy that is left after
paying for consumption and government
purchases.
• If we subtract C and G from total income in the
equation:
Y–C–G=I
• We get national saving (S) on the left hand side.

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Some Important Identities
• We can divide national saving into two parts:
private saving and public saving. Suppose T is
the amount of tax revenues collected by the
government.
S=Y–C–G
• We can also write:
S = (Y – T – C) + (T – G)
National S. = Private S. + Public S.
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Some Important Identities
• Private Saving
– Private saving is the amount of income that
households have left after paying their taxes and
paying for their consumption.
– Private saving = (Y – T – C)

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Some Important Identities
• Surplus and Deficit
– If T > G, the government runs a budget surplus
because it receives more money than it spends.
• The surplus of T - G represents public saving.
– If G > T, the government runs a budget deficit
because it spends more money than it receives in
tax revenue. In this case public saving is negative.
This has been the case in Turkey in most of its
history.

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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)

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The Meaning of Saving and Investment
• Investment is the purchase of new capital.
• Examples of investment:
– You buy $5000 worth of computer equipment for
your business.
– Your parents spend $300,000 to have a new house
built.

Remember:
Remember: In
In economics,
economics, investment
investment is
is NOT
NOT the
the
purchase
purchase ofof stocks
stocks and
and bonds!
bonds!
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The 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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THE MARKET FOR LOANABLE
FUNDS
• Financial markets coordinate the
economy’s saving and investment in
the market for loanable funds.
• The market for loanable funds is the
market in which those who save
supply funds and those who borrow
demand funds.

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Figure 1 The Market for
Loanable Funds
Interest
Rate Supply

5%

Demand

0 $1,200 Loanable Funds

(in billions of dollars)

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 Supply and Demand for
Loanable Funds
• Loanable funds refers to all income that people have
chosen to save and lend out, rather than use for their
own consumption.
• The supply of loanable funds comes from people who
have extra income they want to save and lend out.
• The demand for loanable funds comes from firms and
households that wish to borrow to make investments.

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Supply and Demand for Loanable
Funds
• Interest rate
– Is the price of the loan (credit)
– Is the amount that borrowers pay for loans and the
amount that lenders earn on their saving
– in the market for loanable funds, we use the real
interest rate. Ignore inflation.

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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.

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Supply and Demand for Loanable
Funds
• Government Policies That Affect Saving and
Investment
– Taxes on saving (interest earnings).
– Taxes on investment expenditures.
– Government budget deficits and surpluses.

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 Policy 1: Saving Incentives
• Taxes on interest income substantially reduce the future
payoff from current saving and, as a result, reduce the
incentive to save.
• A tax cut on interest earnings increases the incentive for
households to save at any given interest rate.
– The supply of loanable funds curve shifts right.
– The equilibrium interest rate decreases.
– Amount of investment increases.

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Figure 2 An Increase in the Supply of
Loanable Funds
Interest
Supply, S1 S2
Rate

1. Tax incentives for

5%
saving increase the
supply of loanable
4%
funds . . .

2. . . . which Demand
reduces the
equilibrium
interest rate . . .

0 $1,200 $1,600 Loanable Funds

(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.

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Policy 1: Saving Incentives
• If a change in tax law encourages greater
saving, the result will be lower interest rates
and greater saving and investment.

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Policy 2: Investment Incentives
• An investment tax credit increases the
incentive to borrow.
• Increases the demand for loanable funds.
• Shifts the demand curve to the right.
• Results in a higher interest rate and a greater
quantity saved and invested.

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Figure 3 Investment Incentives Increase the
Demand for Loanable Funds
Interest
Rate Supply
1. An investment
tax credit
6% increases the
demand for
5% loanable funds . . .

2. . . . which
raises the D2
equilibrium
interest rate . . . Demand, D1

0 $1,200 $1,400 Loanable Funds

(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.

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Policy 2: Investment Incentives
• If a change in tax laws encourages greater
investment, the result will be higher interest
rates and greater saving and investment.

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 Policy 3: Government
Budget Deficits and
Surpluses
• When the government spends more than it
receives in tax revenues, the short fall (G - T)
is called the budget deficit (flow concept).
• Government borrows to finance its deficit.
Issues and sells bonds in the bond market.
• The accumulation of past budget deficits is
called the government debt (stock concept).

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 Policy 3: Government
Budget Deficits and
Surpluses
• Government borrowing to finance its budget deficit
reduces the supply of loanable funds available to finance
investment by firms.
• This fall in investment is referred to as crowding out.
– The deficit borrowing crowds out private borrowers
who are trying to finance investments. Also keeps
interest rate very high.

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Policy 3: Government Budget Deficits
and Surpluses
• 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.

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Figure 4: The Effect of a Government
Budget Deficit
Interest S2
Rate Supply, S1

1. A budget deficit
6%
decreases the
5% supply of loanable
funds . . .

2. . . . which
raises the
equilibrium Demand
interest rate . . .

0 $800 $1,200 Loanable Funds

(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.

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Policy 3: Government Budget Deficits
and Surpluses
• When government reduces national saving by
running a deficit, the interest rate rises and
investment falls.
• A budget surplus increases the supply of
loanable funds, reduces the interest rate, and
stimulates investment.

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Function of the Financial System
• The financial system consists of the group of institutions
in the economy that perform the essential function of
channeling funds from economic players that have saved
surplus funds to those that have a shortage of funds.
• Promotes economic efficiency by producing
an efficient allocation of capital, which increases
production.
• Improve the well-being of consumers by allowing them
to time purchases better.

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