CHAPTER 26

Savings, Investment Spending, and the Financial System

PowerPoint® Slides by Can Erbil

© 2005 Worth Publishers, all rights reserved

What you will learn in this chapter:

The relationship between savings and investment spending

About the loanable funds market, which shows how savers are matched with borrowers

The purpose of the four principal types of assets: stocks, bonds, loans, and bank deposits

How financial intermediaries help investors achieve diversification

Some competing views of what determines stock prices and why stock market fluctuations can be a source of macroeconomic instability

The Savings–Investment Spending Identity in a Closed Economy

In a closed economy: GDP = C + I + G

SPrivate = GDP + TR − T − C

SGovernment = T − TR − G

NS = SPrivate + SGovernment = (GDP + TR − T − C) + (T − TR − G)

= GDP − C − G

Hence, I = NS

Investment spending = National savings in a closed economy

Budget Surplus and Budget Deficit

The Savings–Investment Spending Identity in an Open Economy

I = SPrivate + SGovernment + (IM – X) = NS + KI (10)

Investment spending = National savings + Capital inflow in an open economy

The Savings-Investment Spending Identity in Open Economies: the United States and Japan 2003

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

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!

Remember: In economics, investment is NOT the purchase of stocks and bonds!

The Market for Loanable Funds

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

The Market for Loanable Funds

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.

The Market for Loanable Funds

The supply of loanable funds comes from saving: Households with extra income can loan it out

and earn interest.

SHIFTS in the Supply Curve:

Changes in private savings behavior Changes in capital flows

The Slope of the Supply Curve

InterestRate

Loanable Funds ($billions)

Supply

An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.

60

3%

80

6%

The Market 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.

• SHIFTS in the Demand Curve• Changes in perceived business opportunities• Changes in government’s borrowing

The Slope of the Demand Curve

InterestRate

Loanable Funds ($billions)

Demand

A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.

50

7%

4%

80

Equilibrium

InterestRate

Loanable Funds ($billions)

Demand

The interest rate adjusts to equate supply and demand. Supply

The eq’m quantity of L.F. equals eq’m investment and eq’m saving.

5%

60

Policy 1: Saving Incentives

InterestRate

Loanable Funds ($billions)

D1

Tax incentives for saving increase the supply of L.F.S1

5%

60

S2

…which reduces the eq’m interest rateand increases the eq’m quantity of L.F.

4%

70

Policy 2: Investment Incentives

InterestRate

Loanable Funds ($billions)

D1

An investment tax credit increases the demand for L.F.S1

5%

60

…which raises the eq’m interest rateand increases the eq’m quantity of L.F.

6%

70

D2

AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : Exercise A.Exercise A.

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?

18

AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : Exercise B.Exercise B.

Use the loanable funds model to analyze the effects of tax decrease on the interest earned on savings. How does the tax decrease on interest on savings affect the market?

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?

19

Policy 3. Government Budgets

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

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.

U.S. Government Debt U.S. Government Debt as a Percentage of GDP, 1970-2007as a Percentage of GDP, 1970-2007

0%

20%

40%

60%

80%

100%

120%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Revolutionary War

Civil War

WW1

WW2

The Financial System - Definitions

Wealth Financial asset Physical asset Liability Transaction costs Financial risk

Risk-Averse Attitudes Toward Gain and Loss

Three Tasks of a Financial System

Reducing transaction costs Reducing financial risk Providing liquid assets

Financial Intermediaries

Mutual funds

Pension funds

Life insurance companies

Banks

Financial Fluctuations

Financial market fluctuations can be a source of macroeconomic instability.

Are markets irrational?

Policy makers assume neither that markets always behave rationally nor that they can outsmart them.

The End of Chapter 26

coming attraction:Chapter 27:

Aggregate Supply and Aggregate Demand