N.

GREGORY MANKIW NINTH EDITION

PRINCIPLES OF
ECONOMICS

CHAPTER
Saving, Investment, and the
26 Financial System
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
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 IN THIS CHAPTER
• What are the main types of financial
institutions in the U.S. 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 government policies affect saving,
investment, and the interest rate?
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2
 Financial Institutions
• Financial system
– Group of institutions in the economy
– That help match the saving of one person
with the investment of another
• Financial institutions
– Institutions through which savers can
directly provide funds to borrowers
1. Financial markets
2. Financial intermediaries
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 Financial Markets
• Financial markets
– Financial institutions through which savers
can directly provide funds to borrowers
• 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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 The Bond Market
• Bond is an IOU that specifies:
– Principal: the amount borrowed
– Date of maturity: the time at which the loan will
be repaid
– Rate of interest that the borrower will pay
periodically until the loan matures.
– Bond buyer is a lender: can hold the bond until
maturity, or he can sell the bond at an earlier
date to someone else
• Debt finance: sale of bonds to raise money

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 Four Characteristics of Bonds – 1
• Term: length of time until the bond matures
– Short terms or long terms
• Long term bonds: riskier, higher interest
– Never matures: perpetuity
• Credit risk: probability of borrower default
– High probability of default: higher interest
– Junk bonds (issued by financially shaky
corporations) pay very high interest rates

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 Four Characteristics of Bonds – 2
• Tax treatment: way the tax laws treat the
interest earned on the bond
– Interest on most bonds is taxable income
– Municipal bonds (issued by state and local
governments): no tax, lower interest rates
• Does it offer inflation protection?
– Nominal terms: specific number of dollars
– Indexed to a measure of inflation: when prices
rise, the payments rise proportionately (lower
interest rates)

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 The Stock Market – 1
• A share of stock: ownership in a firm
– Therefore is a claim to some of the profits that
the firm makes
– Carry greater risk but offer potentially higher
returns
• Equity finance: sale of stock to raise money
• Stock exchange
– Trading stock shares stockholders
– The business (that issued the stock) receives
no money
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 The Stock Market – 2
• Prices of shares on stock exchanges
– Determined by the supply of and demand for the
stock in these companies.
• The demand for a stock
– Reflects people’s perception of the corporation’s
future profitability
• A stock index: an average of a group of
stock prices
– Dow Jones Industrial Average
– Standard & Poor’s 500 Index
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 Financial Intermediaries – 1
• Financial intermediaries
– Institutions through which savers can
indirectly provide funds to borrowers
– Banks
– Mutual funds

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 Banks
• Primary role for banks:
– Take in deposits from savers (small interest rate)
– Use these deposits to make loans to borrowers
(charge a higher interest rate)
• Secondary role of banks:
– Facilitate purchases of goods and services
• Checks and debit cards to access deposits
• Medium of exchange
• Store of value

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 Mutual Funds
• Mutual funds:
– Sell shares to the public and use the proceeds to
buy portfolios of stocks and bonds
• Advantages:
– Allow people with small amounts of money to
diversify their holdings (less risk)
– Give ordinary people access to the skills of
professional money managers
• Financial economists, skeptical: hard to “beat
the market”

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 Some Important Identities – 1
• Gross domestic product (GDP, Y)
• Total income = Total expenditure
Y = C + I + G + NX
• Y = gross domestic product, GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports

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 Some Important Identities – 2
• Assume closed economy: NX = 0
Y = C + I + G, so I = Y – C - G
• National saving (saving), S = Y – C - G
• Total income in the economy that remains
after paying for consumption and
government purchases
• By definition: S = Y – C – G
• It follows: Saving (S) = Investment (I) for
a closed economy
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 Some Important Identities – 3
• Define T = taxes minus transfer payments
S = Y – C – G can be rewritten as:
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
National saving (S) = Private saving + Public saving
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 Budget Surplus or Deficit
• Budget surplus: T – G > 0
– Excess of tax revenue over government
spending = public saving (T-G)
• Budget deficit: T – G < 0
– Shortfall of tax revenue from government
spending = – (public saving) = G – T

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 Active Learning 1: Applying the concepts
You have the following information: GDP = $19
trillion, C = $13 trillion, G = $2.5 trillion, and Budget
deficit = $1.2 trillion.
A. Find public saving, net taxes, private saving,
national saving, and investment.
B. Government cuts taxes by $300 billion. Find
new budget deficit and answers to A. if:
a) Consumers save the entire tax cut
b) Consumers save 1/3 and spend the other 2/3
of the tax cut

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 Active Learning 1: Answers, A
Y = $19 tn., C = $13 tn. G = $2.5 tn., and Budget
deficit = G – T = $1.2 tn.
• Public saving = T – G = – $1.2 tn.
• Net taxes T = $1.3 tn.
G – T = 1.2, G = 2.5, So T = 2.5 – 1.2 = 1.3
• Private saving = $4.7 tn.
= Y – T – C = 19 – 1.3 – 13 = 4.7
• National saving = investment, S = I = $3.5 tn.
S = Y – C – G = 19 – 13 – 2.5 = 3.5
S = private + public saving = 4.7 – 1.2 = 3.5
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 Active Learning 1: Answers, B: Tax cut = $0.3
tn.
a) consumers b) consumers save 1/3
save the tax cut and spend 2/3 of tax cut
Increase in C: 0 1/3 of 0.3 tn. = $0.1 tn.
Net taxes, T 1.3 - .3 = $1 tn. It ↓by $0.3 tn.
Budget deficit 1.2 + 0.3 = $1.5 tn.
=G–T It ↑ by the tax cut of $0.3 tn.
Public saving = - $1.5 tn.
=T–G = - budget deficit
Private saving $5 tn. $4.8 tn.
=Y–T–C It ↑ by $0.3 tn. It ↑ by $0.2 tn.
National saving, S $3.5 tn. $3.3 tn.
= Investment, I Unchanged It ↓ by $0.2 tn.
=Y–C–G

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 The Meaning of Saving and Investment – 1
• Private saving
– 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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 The Meaning of Saving and Investment – 2
• Investment
– Is the purchase of new capital
– Examples of investment:
• General Motors spends $250 million to build
a new factory in Ohio.
• You buy $5,000 worth of computer equipment
for your business.
• Your parents spend $300,000 to have a new
house built.
Investment is NOT the purchase of stocks and bonds!

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 The Market for Loanable Funds – 1
• Loanable funds market
– A supply–demand model of the financial
system
– Helps us understand:
• How the financial system coordinates
saving & investment.
• How government policies and other factors
affect saving, investment, the interest rate.

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 The Market for Loanable Funds – 2
• 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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 The Supply of Loanable Funds
• Saving is the source of the supply of
loanable funds:
– 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.

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

3%

60 80 Loanable Funds
($ billions)

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 The Demand for Loanable Funds
• Investment is the source of the demand
for loanable funds:
– 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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 The slope of the demand curve
A fall in the interest rate
Interest
reduces the cost of
Rate borrowing, which
increases the quantity
7%
of loanable funds
demanded.
4%

Demand

50 80 Loanable Funds
($ billions)

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 Equilibrium on the market for loanable funds
Interest The interest rate
Rate adjusts to equate
Supply
supply and demand.
The equilibrium
quantity of loanable
5% funds = equilibrium I
= equilibrium S.

Demand

60 Loanable Funds ($
billions)

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 Reaching Equilibrium
• If interest rate < equilibrium:
– QS < QD, so shortage of loanable funds
• Encourage lenders to raise the interest rate
• Encourage saving (increase QS)
• Discourage borrowing for investment
(decreasing QD)
• If interest rate > equilibrium
– Surplus of loanable funds
– Decrease interest rate
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 ASK THE EXPERTS
Fiscal Policy and Saving
“Sustained tax and spending policies that
boost consumption in ways that reduce the
saving rate are likely to lower long-run living
standards.”

Source: IGM Economic Experts Panel, July 8, 2013.

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30
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 Policy 1: Saving incentives
Interest • Tax incentives for
Rate
saving increase the
S1 S2 supply of loanable
funds
• …which reduces the
5% equilibrium interest
4% rate
• and increases the
D1 equilibrium quantity
of loanable funds
60 70 • greater S and I
Loanable Funds
($ billions)
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 Policy 2: Investment incentives
Interest • An investment tax
Rate
credit increases the
S1 demand for loanable
funds
6% • …which raises the
5% equilibrium interest
rate
D2 • and increases the
D1 equilibrium quantity
of loanable funds
60 70 • greater S and I
Loanable Funds
($ billions)
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 Policy 3: Government Budget Deficits and Surpluses

• Budget deficit G > T

– Excess of government spending over tax
revenue
• Government debt
– Accumulation of past government borrowing
• Budget surplus, T > G
– Excess of tax revenue over government
spending
– Repay some of the government debt.
• Balanced budget: G = T
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 Active Learning 2: Budget deficits and surpluses
Assume the government starts with a balanced
budget and then, because of an increase in
government spending (and/or decrease in taxes),
starts running a budget deficit. Use the loanable
funds model to analyze the effects of a government
budget deficit:
A. Draw the diagram showing the changes in
equilibrium. What happens to the equilibrium
values of the interest rate and investment?
B. Analyze the effects of a budget surplus.

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 Active Learning 2: Answers
Interest A. A budget deficit reduces
Rate
S2 national saving and the
S1 supply of loanable funds
…which increases the
6% equilibrium interest rate
5% and decreases the equilibrium
quantity of loanable funds and
investment.
D1 B. A budget surplus increases
the supply of loanable
funds, reduces the interest
50 60
rate, and stimulates
Loanable Funds
($ billions) investment.
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 Policy 3: Lessons
• Budget deficits
– Reduce national saving
– Decrease the supply of loanable funds
– Interest rate rises and investment falls
• Budget surplus
– Increase national saving
– Increase the supply of loanable funds
– Reduce the interest rate, and stimulates
investment

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 The History of U.S. Government Debt
• The government finances deficits by
borrowing (selling government bonds).
– Persistent deficits lead to a rising government
debt.
• The debt-to-GDP ratio
– 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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 U.S. Government debt as a percentage of GDP,
1790–2012

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 The financial crisis of 2008–2009
A financial crisis led to a deep recession in the U.S. and
around the world. A few unemployment rates:
12
USA
11
France
10
U.K.
9 Canada
8
7
6
5
4
3
01-2007
04-2007
07-2007
10-2007
01-2008
04-2008
07-2008
10-2008
01-2009
04-2009
07-2009
10-2009
01-2010
04-2010
07-2010
10-2010
01-2011
04-2011
07-2011
10-2011
01-2012
04-2012
07-2012
10-2012
01-2013
04-2013
07-2013
10-2013
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 Elements of Financial Crises – 1
1. Large decline in some asset prices
– Housing prices fell 30% (2008-2009).
2. Widespread insolvencies at financial institutions
– Banks and other institutions failed when many
homeowners stopped paying their mortgages.
3. Decline in confidence in financial institutions
– Customers with uninsured deposits began
pulling their funds out of financial institutions

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 Elements of Financial Crises – 2
4. Credit crunch
– Borrowers unable to get loans because troubled
lenders not confident in borrowers’ credit-
worthiness.
5. Economic downturn
– Failing financial institutions and a fall in
investment caused GDP to fall and
unemployment to rise.
6. Vicious circle
– The downturn reduced profits and asset values,
which worsened the crisis.
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 THINK-PAIR-SHARE
You are watching a presidential debate. When a
candidate is questioned about his position on economic
growth, the presidential candidate steps forward and
says, “We need to get this country growing again. We
need to use tax incentives to stimulate saving and
investment, and we need to get that budget deficit down
so that the government stops absorbing our nation’s
saving.”
A. If G remains unchanged, what inconsistency is
implied by the presidential candidate’s statement?
B. If the presidential candidate truly wishes to decrease
taxes and decrease the budget deficit, what has the
candidate implied about his plans for G?
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 CHAPTER IN A NUTSHELL
• The U.S. financial system - many types of financial
institutions: the bond market, the stock market,
banks, and mutual funds. They direct the resources
of households that want to save into the hands of
households and firms that want to borrow.
• National income accounting identities reveal some
important relationships among macroeconomic
variables. For a closed economy, national saving
must equal investment. Financial institutions:
matching one person’s saving with another
person’s investment.

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 CHAPTER IN A NUTSHELL
• The interest rate is determined by the supply and
demand for loanable funds. The supply of loanable
funds: from households that want to save. The
demand for loanable funds: from households and
firms that want to borrow for investment.
• National saving = private saving + public saving.
• A government budget deficit is negative public
saving. Reduces national saving and the supply of
loanable funds available to finance investment.
• Government budget deficit crowds out investment:
reduces the growth of productivity and GDP.
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44