1. Macroeconomics
Lecture 5

2. Saving, Investment & the Financial System
Macroeconomics
Lecture 4
Saving, Investment & the Financial System
Chapter 26

3. Lecture Objectives Learn about financial institutions.
Consider how the financial system is related to key macroeconomic variables.
Develop a model of the supply and demand for loanable funds.
Use the loanable funds model to analyze various government policies.
Consider how budget deficits and surpluses affect the economy.

4. The Financial System
Consist of institutions that help to match one person’s saving with another person’s investment.
Move the economy’s scarce resources from savers to borrowers.

5. Financial Institutions
Categories

6. Financial Institutions Financial Markets
Categories

7. Financial Institutions Financial Intermediaries
Categories

8. Financial Markets Bond Market
A bond: a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond.
Debt financing: sale of bond to raise money
IOU

9. Financial Markets Bond Market
Characteristics of a Bond:
Term
Credit Risk
Tax Treatment

10. Financial Markets Stock Market
represent ownership in a firm  a claim to the profits that the firm makes.
offer both higher risk and potentially higher returns in comparison with bonds
Equity financing
sale of stock to raise money.

11. Financial Intermediaries Banks
Take deposits from people who want to save
Make loans from deposits to people who want to borrow.
pay depositors interest on their deposits
charge borrowers slightly higher interest on their loans.

12. Financial Intermediaries Banks
Create a medium of exchange by allowing people to write checks against their deposits.
A medium of exchanges: an item that people can easily use to engage in transactions, facilitates the purchases of goods and services.

13. Financial Intermediaries Mutual Funds
A mutual fund (USA)/ managed fund (Australia): an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both.
allow people with small amounts of money to easily diversify.

14. Financial Intermediaries Others
Credit unions
Pension funds
Insurance companies
Loan sharks

15. Financial Instruments in the US

16. US household wealth (2014)
Macroeconomics
Lecture 4

17. Saving and Investment in the National Income Accounts
GDP = total income = total expenditure
Y = C + I + G + NX

18. Some Important Identities
A closed economy without international trade:
Y = C + I + G

19. Some Important Identities
Subtract C and G from both sides of the equation:
Y – C – G =I
National saving, or just saving (S): total income in the economy after paying for consumption and government purchases and is called

20. Some Important Identities
Substituting S for Y-C-G
S = I
National saving, or saving:
S = Y – C – G
S = (Y – T – C) + (T – G)
where “T” = taxes - transfers

21. Private Saving & Public Saving
Private saving: the amount of income that households have left after paying their taxes and paying for their consumption.
Public saving: the amount of tax revenue that the government has left after paying for its spending.

22. Surplus and Deficit
T>G: budget surplus
G>T: budget deficit

23. S = I Saving and Investment
For the economy as a whole, saving must be equal to investment.
S = I

24. Saving and Investment in the National Income Accounts
National Saving or Saving:
Y - C - G = I = S or
S = (Y - T - C) + (T - G)
where “T” = taxes - transfers
Two components of national saving:
Private Saving
Public Saving

25. NX= NCO = NCI Y=C+I+G+NX I=(Y-T-C)+ (T-G)-NCO
Open economy
NX= NCO = NCI
Y=C+I+G+NX
I=(Y-T-C)+ (T-G)-NCO

26. The Market for Loanable Funds
Market for loanable funds: coordinate the economy’s saving and investment.
Loanable funds: all income that people have chosen to save and lend out, rather than use for their own consumption.

27. Supply and Demand for Loanable Funds
The supply of loanable funds
The demand for loanable funds

28. Supply and Demand for Loanable Funds
Interest rate: price of the loan.
the amount that borrowers pay for loans
the amount that lenders receive on their saving.
Interest rate in the market for loanable funds: real interest rate.

29. Market for Loanable Funds
Real Interest Rate
Supply
Demand
The equilibrium of the supply and demand for loanable funds determines the real interest rate. E 5%
$1,200
Loanable Funds (in billions of dollars)

30. Government Policies That Affect Saving and Investment
Taxes and saving
Taxes and investment
Government budget deficits

31. Taxes and Saving Taxes on interest income
 substantially reduce the future payoff from current saving and
 reduce the incentive to save.
A tax decrease
 increases the incentive for households to save at any given interest rate.

32. An Increase in the Supply of Loanable Funds
Interest
Rate S2
1. Tax incentives for saving increase the supply of loanable funds...
Supply, S1 5% 4%
2. ...which reduces the equilibrium interest rate...
Demand
$1,600
3. ...and raises the equilibrium quantity of loanable funds.
$1,200
Loanable Funds
(in billions of dollars)

33. Taxes and Saving Change in tax law encouraging saving
 lower interest rates & greater investment
Supply of loanable funds curve
Equilibrium interest rate
Quantity demanded for loanable funds

34. Taxes and Investment
An investment tax credit (tax reduction to encourage investment)  increase the incentive to borrow.
 the demand for loanable funds
the demand curve
interest rate
quantity saved

35. An Increase in the Demand for Loanable Funds
Interest
Rate
Supply
1. An investment tax credit increases the demand for loanable funds... D2 6%
2. ...which
raises the equilibrium interest rate... 5%
Demand, D1
$1,400
3. ...and raises the equilibrium quantity of loanable funds.
$1,200
Loanable Funds
(in billions of dollars)

36. Government Budget Deficits
Government debt

37. Government Budget Deficits
Government borrowing to finance its budget deficit
 reduce the supply of loanable funds available to finance investment by households and firms  Crowding out
Crowding out: fall in private investment due to deficit borrowing

38. The Effect of a Government Budget Deficit
Interest
Rate S2
1. A budget deficit decreases the supply of loanable funds...
Supply, S1
2. ...which raises the equilibrium interest rate... 6% 5%
Demand
$800
3. ...and reduces the equilibrium quantity of loanable funds.
$1,200
Loanable Funds
(in billions of dollars)

39. Government Budget Deficits
A budget deficit  decrease the supply of loanable funds:
Supply curve
Equilibrium interest rate
Equilibrium quantity of loanable funds

40. Government Budget Deficits and Surpluses

41. U.S. government debt (% of GDP 1970-2007)

42. Global loanable fund market
Global intergration
Capital mobility
Real Interest rate differences

43. Global loanable fund market

44. Lecture Review Financial Markets and Intermediaries
Saving and Investment
Market for Loanable Funds
Government policies that affect the economy’s savings and investment
Government Budget deficits and surplus