1. Saving, Investment, and the Financial System
AP Macro
Mr. Warner

2. What you will learn in this Module:
What is the relationship between savings and investment spending?
What is the purpose of the four principal types of financial assets: stocks, bonds, loans and bank deposits?
How do financial intermediaries help investors achieve diversification?

3. Matching up Savings and Investment Spending
Physical Capital
The Source of Physical Capital
When a firm invests in physical capital (factories, shopping malls, large pieces of machinery, etc), the firm usually pays for these big projects by borrowing. Those funds have to come from somewhere.
This module will discuss the source of those funds and the entities that help to provide access to the funds.

4. The Savings-Investment Spending Identity
Assume a simple economy
Total Income = Total Spending
Total Income = Consumption + Savings
Total Spending = Consumption+ Investment
Consumption + Savings = Consumption + Investment .: Savings = Investment
Note: stress from the beginning that savings equals investment. S=I
This is known as the savings–investment spending identity.
We start with the simplest of economies, but it still holds when we bring in the public and foreign sectors.
Simple economy: no government, no trade (zero imports and exports).
Remember the very simple circular flow diagram. All money spent by consumers and firms ends up in another person’s pocket as income (including profit).
Total income = Total spending = C + I
Now, what do people do with income? They either spend it on consumption (C) or save it (S).
Total income = C + S = Total Spending = C + I
C + S = C + I Or
S = I

5. The Savings-Investment Spending Identity
Now, more complexity
Budget Surplus
Budget Deficit
Budget Balance
National Savings v. Private Savings
Capital inflow
OK, what if the economy isn’t so simple.
Add the government (public sector) to the private sector.
The government spends on goods and services (G) and pays transfers to some. The government collects tax revenue to pay for these things.
If the government budget is balanced:
Tax revenue = government spending + transfer payments
Rearrange this equation and call it Budget Balance (BB)
Budget Balance = Tax Revenue – G – transfers
If BB >0, the government has a budget surplus and is actually saving money.
If BB<0, the government has a budget deficit and is borrowing money (dissaving).
We can now include public sector savings to the savings-investment identity.
S + BB: simply total national savings.
S + BB = I
If BB>0 on the left side (a surplus), I must increase on the right side.
If BB<0 on the left side (a deficit), I must decrease on the right side.
Final level of complexity.
Add the foreign sector.
An American can save her money in the US or in another nation.
A foreign citizen can save his money in his home country, or in the US.
So the US receives inflows of funds—foreign savings that finance investment spending in the US.
The US also generates outflows of funds—domestic savings that finance investment spending in another country.
Let’s define:
Capital inflow into the US =total inflow of foreign funds - total outflow of domestic funds to other countries.
Capital inflow (CI) can be positive or negative so it can increase or decrease the total funds available for investment in the US economy.
S + BB + CI = I
If CI > 0 on the left side (more foreign funds coming into the US, than US funds going out), I must increase on the right side.
If CI < 0 on the left side (fewer foreign funds coming into the US, than US funds going out), I must decrease on the right side.

6. The Financial System Wealth Financial Asset Physical Asset Liability
Financial markets are where households invest their current savings and their accumulated savings, or wealth, by purchasing financial assets.
A financial asset is a paper claim that entitles the buyer to future income from the seller.
There are four types of financial assets.
Before we get into those specific assets, we look at the role the financial system plays in exchanging the assets from the seller to the buyer.

7. Three Tasks of a Financial System
Reducing Transaction Costs
Reducing Risk
Financial Risk
Diversification
Providing Liquidity
Liquid
Illiquid
1. Reducing Transaction Costs
Suppose a consumer wanted to buy a loaf of bread, a pound of apples, and a dozen eggs.
One way to do this is to drive to the bakery, then drive to the orchard, and then drive to the farm.
It is surely more convenient, and less costly, to buy from a firm that specializes in providing these items: the supermarket.
Suppose a firm wanted to borrow some money to build a factory.
One way to borrow would be to go to Mr. Jones for a loan, Ms. Sanchez for another loan, the Johnson family for another…
Or the firm could find a firm that specializes in providing these funds: a bank.
The bank, and other financial services companies, is able to make it easier, and less costly, for firms to engage in financial transactions like borrowing to make investments.
2. Reducing Risk
The future is uncertain so investments, like building a factory, have a risk that they will not be profitable.
The owner of a firm may want to build the factory, but using his/her own money is risky bcause the factory might not be profitable.
Or the owner could raise the money by selling shares of stock in the company.
When a person buys a share of stock in a company, it gives that person a small stake in the ownership of the company.
So the primary owner of the business can pay for the factory, but does not need to risk his/her own money if the factory should fail to generate profits.
Diversification: investing in several assets with unrelated, or independent, risks—allows a business owner to lower his/her total risk of loss.
The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and a stock market.
3. Providing Liquidity
Liquidity refers to the ease by which an asset can be converted to cash.
A vintage Rolls Royce is a valuable asset, but isn’t very liquid.
A savings account is very liquid.
If a firm needs money to build a factory, that investment physical asset will not provide a stream of cash revenue for a long time.
Until the factory begins to produce goods that generate revenue, the firm may need liquidity (cash) to purchase raw materials, hire some workers and pay the electric bill.
The financial system can provide liquidity in a variety of ways: by issuing loans, bonds, or stocks.

8. Types of Financial Assets
Loans
Bonds
Default
Loan-backed Securities (Collateralized Debt Obligation - CDO)
Stocks
Note: It is suggested that the instructor not present the following sections in class.
However the students should become familiar with these assets and intermediaries. This is probably best done with a homework assignment.
B. Types of Financial Assets
1. Loans
A loan is a lending agreement between an individual lender and an individual borrower.
2. Bonds
The seller of a bond promises to pay a fixed sum of interest each year and to repay the principal—the value stated on the face of the bond—to the owner of the bond on a particular date.
3. Loan-backed Securities
Loan-backed securities are assets created by pooling individual loans and selling shares in that pool (a process called securitization).
4. Stocks
A stock is a share in the ownership of a company.

9. Financial Intermediaries
Mutual Funds
Pension Funds
Life Insurance Companies
Banks
Bank deposit
Fractional reserve banking
A financial intermediary is an institution that transforms funds gathered from many individuals into financial assets. The most important types of financial intermediaries are mutual funds, pension funds, life insurance companies, and banks.
1. Mutual Funds
A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors.
2. Pension Funds and Life Insurance Companies
Pension funds are nonprofit institutions that collect the savings of their members and invest those funds in a wide variety of assets, providing their members with income when they retire.
Life insurance companies sell policies which guarantee a payment to the policyholder’s beneficiaries (typically, the family) when the policyholder dies.
3. Banks
A bank is a financial intermediary that provides liquid financial assets in the form of deposits to lenders and uses their funds to finance the illiquid investment spending needs of borrowers.