Topic 4 - Saving, Investment and The Financial System - 23B-3

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Macroeconomics 1
Topic 4: Saving, Investment and the Financial
System
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Core Concepts
• The financial system
• The saving and investment’s accounting identity
• Loanable funds market and the role of the government
• The crowding-out effect
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Saving, Investment and the
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living standard
In the long run, total income depends on the production
factors and total factor productivity:
𝒀 = 𝑨 𝒇 ( 𝑲 , 𝑳)
Y is total income (GDP), A is total factor productivity.
For simplicity, we consider only two production factors:
Capital (K) and Labor (L)
* Ignore and of 3
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living standard (2)

The living standard is measured as GDP per Capita =
𝑌 𝐴𝑓 (𝐾 , 𝐿) 𝑌 𝐾 𝐿 𝑌 𝐾
= = 𝐴𝑓 ( , ) = 𝐴𝑓 ( )
𝐿 𝐿 𝐿 𝐿 𝐿 𝐿 𝐿
Let’s think together: Assuming L is constant, what factors can
improve the standard of living in the long run?
𝑌 𝐾
= 𝐴𝑓 ( )
𝐿 𝐿
Investment in R&D Investment in Capital

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How to increase physical capital

per person?
• Remember that household can an economy needs to
divide its total output (Y) for two purposes:
o Instant consumption.
o Investment to increase future consumption.
• Firms need monetary funds to make their investments.
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living standard (3)

Where do firms get the funds to invest from?
Profits re-investment
From households’ savings
How are funds transferred from households to firms?
Directly – Financial Market

Households’ savings
to firms’ investments
Indirectly – Financial intermediaries
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The financial system: How do firms
get the funds for investment?
Directly
(1) Financial Market

• Shares
Households’ • Bonds Firms’
savings investment
Indirectly
(2) Financial Intermediaries

• Banks
• Other financial institutions
(1) Financial Market + (2) Financial Intermediaries = Financial System
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Financial system: the basic
Major financial institutions in the Vietnam economy:

A. Financial Markets (direct channels)
i. Bond Market
ii. Stock Market
B. Financial Intermediaries (indirect channels)

i. Banks
ii. Insurance Companies
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Bond Market
Bonds are investments where an investor lends money to

a company or a government for a set period of time, in
exchange for:
• Regular interest payments,
• Payment of the principal at the date of maturity.
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Examples of bonds
Vietnam government issues a 5-year 1-billlion VND bond on 1/1/2022, the
annual interest rate is 7%:
• At the end of each of the year 2022 – 2026: VN government pays 70

million for the interest rates.
• At the day of maturity (31/12/2016): repay 1 billion of the principal to

investors.
On May 2022, VinGroup issued a total of 525 million USD at 3% interest

rate to international market. The maturity date is on May 10, 2027. For
each piece of 1 million USD, investors will receive:
• Interest rate?  30,000 USD a year in 5 years

• The principal?  1 million on May 10, 2027
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Stock market
A stock is a certificate that represents a claim to partial

ownership in a firm, and hence a share of the profits that the
firm produces.
Firms usually pay parts of its profits to stockholders as

dividends.
Example: if a newly established corporation issues 1,000 shares

of stock, then each share represents a claim to 1/1,000 of the
firm.
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Public company and the stock

exchange
A public company is a company whose ownership is
organized via shares of stock which are intended to be freely
traded on a stock exchange.
Examples:
• Vietnam’s stock exchange: Ho Chi Minh Stock Exchange

(HOSE) or Hanoi Stock Exchange (HNX).
• Vietnam public companies: Vinamilk, Vietcombank, Hoa Phat

Group, Hoa Phat Group …
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Financial Intermediaries
Financial intermediaries are financial institutions through
which savers (lenders) can indirectly lend funds to borrowers.
The role of banks:
1. Accept deposits from savers.
2. Make loans to borrowers.
Example:
• A customer deposits 100 mil VND at 7% interest rate at
Vietcombank. The term is one year.
• Vietcombank lends money to a company at 9% a year.

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Insurance Companies
Insurance companies are financial intermediaries which offer

direct insurance or reinsurance services, providing financial
protection from possible hazards in the future.
• Investors make regular payments (premium) to the insurance
companies (the insurers).
• Insurance companies invest the customers’ money to a portfolio
in the financial market.
• Insurance buyers can withdraw the accumulated premium
(depending on the policy).
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Let’s play the

Saving – Investment Game
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Core Concepts
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The Macroeconomics of Saving and

Investment
• Assuming a closed economy
o no interaction with the rest of the world
• Recall the composition of GDP (expenditure approach):
o NX = 0
o Hence
Total value of Output Total value of

or Income Expenditure
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This is an accounting identity.
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What is an accounting identity?
In accounting, finance and economics, an accounting identity

is an equality that must be true regardless of the value of its
variables, or a statement being true by definition or by
construction).
Examples:
Within a period of time, without changing in net saving, any

person must record:
Total amount of outflow of money = Total amount of inflow of money

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Investment (2)
• Investment (used in economics) refers to the purchase of

new capital, such as equipment or buildings (including
houses of consumers).
o Note: financial investment is a purchase of corporate stocks,
bonds, or other financial assets, so it is not considered as
investment.
• Increase or decrease of inventory – produced in a given
year may be sold in a later time – is also counted as part of
investment.
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Investment (3)
• Inventories are adjusted for excess
𝑌 =𝐶+ 𝐼+𝐺 or shortage in production.
• Then, production and spending are
accounting identities.
At any point in time:
• If production is higher than spending, excess production is added to spending

as Inventory Investment (I )
• If spending is higher than production, excess spending is subtracted from

Inventory Investment (I )
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Government Purchases (G) and

Consumption (C)
• Government purchases (G): All spending on the goods
and services purchased by the government. This is funded
by taxes (T).
o Excludes transfer payments (TR) (directly giving money to

the citizens). Example: Vietnam government subsidies the
over-80 elderly ~4 million VND a month.
• Consumption (C): Total spending by households on goods

and services.
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Vietnam Example of Y = I + G + C
Vietnam GDP by Expenditure (exclude NX) (2020)
I: Investment
32.8%
G: Government's Spend-
ing
57.5%
C: Household's Consump-
9.7% tion
Sources: GSO 22
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Why 𝑌 = 𝐶 + 𝐼 + 𝐺 is important?
Accounting identity is helpful to do economic
analysis.
Assumed that an economy has not reached its full capacity, any changes
in GDP must involve changes in all three components that add up to
the overall change.
GDP grows by 7%, it can be induced by:
• C must increase by 7%.
• I must increase by 7%.
• G must increase by 7%.
During the massive Covid lockdown in 2020 and 2021, the C component
– the willingness to consume by households – decreased. GDP growth
rate of Vietnam declined (from 7.4% to 2.9%).
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Vietnam pre-Covid’s vs Covid’s

years
2019 2020
Overall GDP Growth Rate
7.4% 2.9%
contributions from growth of:
I: Investment 7.5% 4.1%
G: Government's Spending 5.4% 1.2%
C: Households' Consumption 7.0% 0.4%
Sources: GSO
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Investment: the Relationship between

Saving and Investment (4)
• In macroeconomics, saving is defined as part of total

income (Y) that is not used for consumption.
• In other words, the total (national) saving:
• Therefore, in a closed economy (, saving must always

equal investment:
• This is also an accounting identity.

• Implication?
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Investment (5)
• Now let’s define two types of saving:
• Total Saving () = Private Saving ( + Public Saving (
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Investment (6)
Private saving is :
• the amount of income that households have left after

paying their taxes and spending on their consumption.
• equal to households’ disposable income that is not used for

consumption:
S private =( Y +TR −T ) −C
Disposable income
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Investment (7)
Public saving is:
• the amount of tax revenue that the government has left

after paying for its spending.
• equal to government’s tax revenue minus transfers minus

expenditure:
S public =T −TR −G
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Investment (8)
Note further on the public saving that:

o Whenever , the government runs a budget surplus
because it receives tax revenue more than it spends.
o But if , the government runs a budget deficit because it
spends more money than it receives as taxes.
o If government spending equals tax revenue (), the
government has a balanced budget.
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Budget deficit and Government

debt
• Government issues public debt (government bonds) to
finance its budget deficit.
• Most of countries are running budget deficit.
• The entire amount of government bonds outstanding,

representing the accumulation of past government deficits,
is the government debt.
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Government Debt as % GDP
Vietnam’s government debt is at 43.1% of GDP in 2021.

Sources: Ministry of Finance
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Inducing more investment?
Saving must always equal investment:
with .
Disposable Income
This is an identity accounting (hold true by definition).

How to induce higher investments to lead higher income in
the future?
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The macroeconomics of Saving and

Investment (9)
Positive long-run economic impact.

Higher saving rates
Increase in capital stock, higher
implies higher investment
labor productivity, increase in R&D
 Higher consumption in the future
Higher saving rates also

Negative short-run economic impact
implies lower Decrease is demand for goods and
consumption today services
Is saving good or bad?

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Differences in Investment Rates

among Selected Countries
Gross Capital Formation - approximately as

Investment (I) (% of GDP) in 2019
43.3
30.2 31.5
25.8
22.1 23.3 23.8
21.0 21.4
17.9 18.2
UK ly ia es y lia nd n ia ea na
I ta s at an a a ap
a d r i
ay t m st
r
ai
l In Ko Ch
al S er u h J
h
M
it ed G A T
o ut
Un S
Sources: World Bank 34

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Study plan
• Loanable funds market and the role of the government
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Theory of Market for Loanable
Funds
Now we will study how the funds from saving and
for investment are traded in the market.
Households saving Households

Householdsand Firms in-
and Firms
investment
vestment
Willingness to lend
at a price = interest rate Willingness to borrow at
a price = interest rate
Supply of Demand for

loanable funds loanable funds
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Theory of Market for Loanable
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Funds
Supply of Demand for
At a higher interest rate higher the supply of loanable funds
The supply curve is an upward sloping curve
At a higher interest rate lower the demand for loanable funds

The demand curve is a downward sloping curve
Let’s see it on a graph!
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Market for Loanable funds
Saving-investment Identity
o The two sides represent the two forces (demand and supply)
of the loanable funds market:
• Left side: the supply of loanable funds
• Right side: the demand for loanable funds
o investment :
• Notice that this is an accounting identity, it means that by

definition saving and investment equality always holds.
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Demand for loanable funds

• The demand for loanable Real
Interest
funds (DLF) comes from the Rate (r)
investment () of firms. r 2
o The demand curve is r1
downward sloping
DLF
because a higher interest (for)
0 2 1
Q LF Q LFQuantity of
rate discourages
Loanable Funds (QLF)
borrowing to finance (new)
capital projects. 39
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Supply of loanable funds

• The supply of loanable funds Real
SLF
Interest
Rate (r) (from
(SLF) comes from people who national
saving)
have some extra income and r 2
want to save (and lend out). r1

o The supply curve is upward
sloping because individuals
0 1 2
will save (supply loanable Q LF Q LF Quantity of
Loanable Funds (QLF)
funds) more if the real
interest rate is high, and
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vice versa.
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Market for Loanable funds: Equilibrium

(1)
. Supply of Demand for

Interest Supply (S)
rate
(%)
.............................................
r*
Demand (D)
Q* Loanable funds
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Market for Loanable funds: Equilibrium (2)
• Like any market, the price of the loanable funds (the real
interest rate) adjusts to reach the equilibrium as demand
and supply of loanable funds meet.
o If , the surplus of loanable funds () will drive the real interest
rate to move downward to the equilibrium level.
o If , the shortage of loanable funds () will push the real interest
rate upward to move to the equilibrium level.
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Surplus of
loanable funds
()
drive the real
interest rate
downward to the
equilibrium level.
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push the real

interest rate
Shortage of
loanable funds upward to the
()
equilibrium level.
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Governmental Policies
How can government affect the market of
loanable funds?
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Policy 1: Taxes and Saving

• Recall: “people respond to incentives”
• Taxes on interest income:
• Substantially reduce the future pay-off from current

saving and, as a result, reduce the incentive to save.
• Hence, an increase in taxes on interest income

decreases the incentive for households to save at any
given interest rate and vice versa.
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Interest Income vs Other Incomes
• Interest income: the money obtains from deposit accounts

(at banks), government bonds, or corporate bonds (from
firms).
• Other incomes: salary income, capital gains (investment

income), rents …
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A Decrease in Interest Income Tax
• Change in tax  change

Interest rate
in saving  shift in supply (%)
Supply, S1
of loanable funds S2
A B
• Decrease in income tax r1
C
r2
 saving more  Supply
of loanable funds shifts to Demand, D
the right
Q1 Q2 Q3 Loanable funds
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A Decrease in Interest Income Tax (2)
• As result, the market

Interest rate
equilibrium will move to (%)
Supply, S1
the new one (point C) S2
from the old one (point A) A B

r1
C
r2
o Interest rate falls
o Quantity of loanable fund Demand, D
increases Q1 Q2 Q3 Loanable funds
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A Decrease in Interest Income Tax (3)
• Cutting income tax could

Interest rate
encourage greater (%)
Supply, S1
saving, which in turn S2
reduces interest rate and A B

r1
C
leads to greater r2
investment.
Demand, D
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Policy 2: Taxes and investment

• An investment tax credit increase the incentive to borrow.
 Investment tax credit: the policy individuals or businesses

deduct a certain percentage of investment costs from their
taxes.
 Example: investing on solar energy gets 26% tax credit in the

US.
• If a change in tax laws encourages greater investment, the

result will be higher interest rates and greater saving.
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An Investment Tax Credit
• An investment tax Interest

rate (%)
credit  Increase in Supply, S1
investment  C
r2
A
Increase in demand r1
B
for loanable funds 

D2
Demand for loanable
Demand, D
funds shifts to the
right Q1 Q2 Q3Loanable funds
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An Investment Tax Credit (2)
• As result, the market Interest

rate (%)
equilibrium will move to Supply, S1
the new one (point C) C

r2
A
from the old one (point A) r1
B
o Interest rate rises

D2
o Quantity of loanable Demand, D
fund rises
Q1 Q2 Q3Loanable funds
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An Investment Tax Credit (3)
• A change in tax law Interest

rate (%)
(introducing an Supply, S1
investment tax credit) C

r2
A
could encourage greater r1
B
investment, the result

D2
would be higher interest
Demand, D
rates and greater saving.
Q1 Q2 Q3Loanable funds
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Policy 3: Government budgets –

Surplus or Deficit
• : Budget deficit
• Assumption: Government competes with business for fixed

saving.
• Government’s borrowing to finance its budget deficit reduces the

supply of loanable funds available to finance investment by
firms.
• The corresponding fall in investment is referred to as the

crowding-out effect.
• Budget deficit decreases the supply of loanable funds.

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The Effect of a Government Budget

Deficit
Interest
• Budget deficit 
rate (%)
S2
negative public saving
Supply, S1
 lowering national
C
saving (S)  reducing r2
A
r1 B
S of loanable funds 
shift the S curve to the
left. Demand, D
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Deficit
• A decrease in S of LF leads
Interest
to an increase in interest rate (%)
S2
rate. This in turn Supply, S1
discourages some
C
demanders of LF r2
r1 B A
Demand, D
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Deficit (2)
• As result, the market Interest

rate (%)
equilibrium will move to S2
Supply, S1
the new one (point C)
from the old one (point C
r2
B
A) r1 A
o Interest rate rises
Demand, D
o Quantity of loanable
fund falls Loanable funds
Q3 Q2 Q1
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Deficit (3)
• When the government Interest

rate (%)
reduces national saving S2
Supply, S1
by running a budget
deficit, the real interest C
r2
B
rate rises and r1 A
investment falls
Demand, D
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Question 1
Which ones of these will happen, when the gov’t runs a
budget deficit/surplus?
A. Increase in supply of loanable funds
B. Decrease in supply of loanable funds
C. Rise in interest rate
D. Fall in interest rate
E. Rise in investment
F. Fall in investment
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Why would a government

keep a budget deficit?
Time inconsistency or necessary economic
stimulus?
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Summary
• The financial system is made of financial institutions such
as the bond market, the stock market, banks and other
financial institutions
• All these institutions act to direct the resources of

households who want to save some of their income into the
hands of households and firms who want to borrow
• The interest rate is determined by the supply and demand

for loanable funds
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Summary 2
• National income accounting identities reveal that in a
closed economy, national saving must equal investment
• A government budget deficit represents negative public

saving and, therefore, reduces national saving and the
supply of loanable funds
• When a government budget deficit crowds out investment,

it (debatably) reduces the growth of productivity and GDP
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RMIT

• The saving and investment’s accounting identity

• Loanable funds market and the role of the government

• The crowding-out effect

living standard (2)

Investment in R&D Investment in Capital

How to increase physical capital

o Investment to increase future consumption.

• Firms need monetary funds to make their investments.

living standard (3)

From households’ savings

How are funds transferred from households to firms?

Directly – Financial Market

(1) Financial Market

(2) Financial Intermediaries

Financial system: the basic

Major financial institutions in the Vietnam economy:

ii. Stock Market

B. Financial Intermediaries (indirect channels)

ii. Insurance Companies

Bonds are investments where an investor lends money to

• Regular interest payments,

• Payment of the principal at the date of maturity.

• At the end of each of the year 2022 – 2026: VN government pays 70

• At the day of maturity (31/12/2016): repay 1 billion of the principal to

On May 2022, VinGroup issued a total of 525 million USD at 3% interest

• Interest rate?  30,000 USD a year in 5 years

A stock is a certificate that represents a claim to partial

Firms usually pay parts of its profits to stockholders as

Example: if a newly established corporation issues 1,000 shares

Public company and the stock

• Vietnam’s stock exchange: Ho Chi Minh Stock Exchange

• Vietnam public companies: Vinamilk, Vietcombank, Hoa Phat

• Vietcombank lends money to a company at 9% a year.

Insurance companies are financial intermediaries which offer

Let’s play the

• The saving and investment’s accounting identity

The Macroeconomics of Saving and

• Recall the composition of GDP (expenditure approach):

Total value of Output Total value of

What is an accounting identity?

In accounting, finance and economics, an accounting identity

Within a period of time, without changing in net saving, any

Total amount of outflow of money = Total amount of inflow of money

The Macroeconomics of Saving and

• Investment (used in economics) refers to the purchase of

The Macroeconomics of Saving and

At any point in time:

• If production is higher than spending, excess production is added to spending

• If spending is higher than production, excess spending is subtracted from

Government Purchases (G) and

o Excludes transfer payments (TR) (directly giving money to

• Consumption (C): Total spending by households on goods

Vietnam GDP by Expenditure (exclude NX) (2020)

GDP grows by 7%, it can be induced by:

• C must increase by 7%.

• I must increase by 7%.

• G must increase by 7%.