7 FINANCE,

SAVING, AND
INVESTMENT
After studying this chapter, you will be able to:
 Describe the flow of funds in financial markets
 Explain how saving and investment decisions are
made and how they interact in financial markets
 Explain how governments influence financial
markets
 Financial Markets and
Financial Institutions
To study the economics of financial institutions and
markets we distinguish between
 Finance and money
 Physical capital and financial capital
Finance and Money
The study of finance looks at how households and firms
obtain and use financial resources and how they cope with
the risks that arise in this activity.
The study of money looks at how households and firms
use it, how much of it they hold, how banks create and
manage it, and how its quantity influences the economy.
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 Financial Markets and
Financial Institutions
Physical Capital and Financial Capital
Physical capital is the tools, instruments, machines,
buildings, and other items that have been produced in the
past and that are used today to produce goods and
services.
The funds that firms use to buy physical capital are called
financial capital.

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 Financial Markets and
Financial Institutions
Capital and Investment
Gross investment is the total amount spent on purchases
of new capital and on replacing depreciated capital.
Depreciation is the decrease in the quantity of capital that
results from wear and tear and obsolescence.
Net investment is the change in the quantity of capital.
Net investment = Gross investment  Depreciation.

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 Financial Markets and
Financial Institutions
Figure 7.1 illustrates the
relationships among the
initial capital, depreciation,
gross investment, and net
investment.

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 Financial Markets and
Financial Institutions
Wealth and Saving
Wealth is the value of all the things that people own.
Saving is the amount of income that is not paid in taxes or
spent on consumption goods and services.
Saving increases wealth.
Wealth also increases when the market value of assets
rises—called capital gains—and decreases when the
market value of assets falls—called capital losses.

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 Example

End of the school year: $250

 Wealth = $250
During the summer you earn: $5000 (income)
During the summer you spend: $1000 (consumption)

How much your bank account?

$4250
Your wealth has increased: $4000 = Saving
Saving = Income – consumption expenditure

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 Financial Markets and
Financial Institutions
• To make real GDP grow, saving and wealth must be
transformed to investment and capital
• This transformation takes place in the markets for
financial capital and through the activities of financial
institutions

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 Financial Markets and
Financial Institutions
Financial Capital Markets
Saving is the source of funds used to finance investment.
These funds are supplied and demanded in three types of
financial markets:
 Loan markets
A firm gets a loan , family gets a mortgage loan
 Bond markets
Firms to expand their business they sell bonds
Bond: coupon payment, redemption payment.
Term of Maturity, yield curve (varies with maturity and
risks)
 Stock markets
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 Financial Markets and
Financial Institutions
Financial Institutions
A financial institution is a firm that that operates on both
sides of the markets for financial capital--a borrower in one
market and a lender in another.
Banks (accept deposits and use the funds ...)
 Trust and Loan Companies (own by banks, personal and
mortgage loans)
 Credit Unions (banks owned by its depositors and borrowers,
under provincial rules)
 Mutual funds (savors  buy bonds and stocks)
 Pension funds (pension contributions  diversified portfolio)
 Insurance companies (risk sharing services)
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 Financial Markets and
Financial Institutions
Insolvency and Illiquidity
A financial institution’s net worth is the total market value
of what it has lent minus the market value of what it has
borrowed.
If net worth is positive, the institution is solvent and can
remain in business.
But if net worth is negative, the institution is insolvent and
go out of business.

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 Financial Crisis: The fall of 2008
• 2002 – 2006 US mortgage borrowing to buy home
exploded
• Home prices doubled in this period
• Mortgages increased from 65% of income to 100%
• Banks soled their mortgages to Fannie Mae and Freddie
Mac
• They bundled these loans into mortgage-backed
securities and sold them globally.
• Home prices began to fall in 2007
• Mortgage loans became bigger than the value of homes
•  Mortgage gage default jumped  MBS values fell
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 Financial Crisis: The fall of 2008
• Biggest financial crisis since the Great Depression.
• securities, such as mortgage-backed securities, lost
value and many financial institutions became insolvent.
• Fannie Mae, Freddie Mac, Bear Sterns, AIG, and
others were considered “too large” to fail.
• If these institutions failed many borrowers would find it
significantly more costly to arrange loans.
• The government bailout: government loans or purchase
stocks (AIG, $85 billion); taken into government
oversight (Fannie Mae and Freddie Mac); merged into
healthier companies, (Bear Sterns); or allowed to fail
(Lehman Brothers).
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 Financial Markets and
Financial Institutions
Interest Rates and Asset Prices
The interest rate on a financial asset is the interest
received expressed as a percentage of the price of the
asset.
Interest rate = (interest payment/price of asset)*100
For example, if the price of the asset is $50 and the
interest is $5, then the interest rate is 10 percent.
If the asset price rises (say to $200), other things
remaining the same, the interest rate falls (2.5 percent).
If the asset price falls (say to $20), other things remaining
the same, the interest rate rises (to 25 percent).
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 Financial Markets and
Financial Institutions
Funds that Finance Investment
Funds come from three sources:
1. Household saving S
2. Government budget surplus (T – G)
3. Borrowing from the rest of the world (M – X)
Figure 7.2 on the next slide illustrates the flows of funds
that finance investment.

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 Financial Markets and
Financial Institutions
The Real Interest Rate
The nominal interest rate is the number of dollars that a
borrower pays and a lender receives in interest in a year
expressed as a percentage of the number of dollars
borrowed and lent.
For example, if the annual interest paid on a $500 loan is
$25, the nominal interest rate is 5 percent per year.

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 Financial Markets and
Financial Institutions
The real interest rate is the nominal interest rate adjusted
to remove the effects of inflation on the buying power of
money.
The real interest rate is approximately equal to the nominal
interest rate minus the inflation rate.
For example, if the nominal interest rate is 5 percent a
year and the inflation rate is 2 percent a year, the real
interest rate is 3 percent a year.
The real interest rate is the opportunity coast of borrowing.

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 The Loanable Funds Market

The market for loanable funds is the aggregate of all the

individual financial markets.
The market for loanable funds determines the real interest
rate, the quantity of funds loaned, saving, and investment.
We’ll start by ignoring the government and the rest of the
world.
The Demand for Loanable Funds
The quantity of loanable funds demanded depends on
1. The real interest rate
2. Expected profit

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 The Loanable Funds Market

The Demand for Loanable Funds Curve

The demand for loanable funds is the relationship
between the quantity of loanable funds demanded and the
real interest rate when all other influences on borrowing
plans remain the same.
Business investment is the main item that makes up the
demand for loanable funds.

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 The Market for Loanable Funds

Figure 7.3 shows the

demand for loanable funds
curve.
A rise in the real interest
rate decreases the quantity
of loanable funds
demanded.
A fall in the real interest rate
increases the quantity of
loanable funds demanded.

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 The Loanable Funds Market

Changes in the Demand for Loanable Funds

When the expected profit changes, the demand for
loanable funds changes.
Other things remaining the same, the greater the expected
profit from new capital, the greater is the amount of
investment and the greater the demand for loanable funds.

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 The Loanable Funds Market

The Supply of Loanable Funds

The quantity of loanable funds supplied depends on
1. The real interest rate
2. Disposable income
3. Expected future income
4. Wealth
5. Default risk

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 The Loanable Funds Market

The Supply of Loanable Funds Curve

The supply of loanable funds is the relationship between
the quantity of loanable funds supplied and the real
interest rate when all other influences on lending plans
remain the same.
Saving is the main item that makes up the supply of
loanable funds.

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 The Market for Loanable Funds

Figure 7.4 shows the supply

of loanable funds curve.
A rise in the real interest
rate increases the quantity
of loanable funds supplied.
A fall in the real interest rate
decreases the quantity of
loanable funds supplied.

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 The Loanable Funds Market

Changes in the Supply of Loanable Funds

A change in disposable income, expected future income,
wealth, or default risk changes the supply of loanable
funds.
An increase in disposable income, a decrease in expected
future income, a decrease in wealth, or a fall in default risk
increases saving and increases the supply of loanable
funds.

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 The Loanable Funds Market

Equilibrium in the Loanable Funds Market

The loanable funds market is in equilibrium at the real
interest rate at which the quantity of loanable funds
demanded equals the quantity of loanable funds supplied.

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 The Loanable Funds Market

Figure 7.5 illustrates the

loanable funds market.
At 7 percent a year, there is
a surplus of funds and the
real interest rate falls.
At 5 percent a year, there is
a shortage of funds and the
real interest rate rises.
Equilibrium occurs at a real
interest rate of 6 percent a
year.

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 The Loanable Funds Market

Changes in Demand and Supply

Financial markets are highly volatile in the short run but
remarkably stable in the long run.
Volatility comes from fluctuations in either the demand for
loanable funds or the supply of loanable funds.
These fluctuations bring fluctuations in the real interest
rate and in the equilibrium quantity of funds lent and
borrowed.
They also bring fluctuations in asset prices.

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 The Loanable Funds Market

Figure 7.6(a) illustrates an

increase in the demand for
loanable funds.
An increase in expected
profits increases the
demand for funds today.
The real interest rate rises.
Saving and quantity of
funds supplied increases.

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 The Loanable Funds Market

Figure 7.6(b) illustrates an

increase in the supply of
loanable funds.
If one of the influences on
saving plans changes and
saving increases, the
supply of funds increases.
The real interest rate falls.
Investment increases.

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 Government in the Loanable
Funds Market
Government enters the financial loanable market
when it has a budget surplus or deficit.
 A government budget surplus increases the supply
of funds.
 A government budget deficit increases the demand
for funds.

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 Government in the Loanable
Funds Market
Figure 7.7 illustrates the
effect of a government
budget surplus.
A government budget
surplus increases the
supply of funds.
The real interest rate falls.
Investment increases.
Private saving decreases.

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 Government in the Loanable
Funds Market
Figure 7.8 illustrates the
effect of a government
budget deficit.
A government budget deficit
increases the demand for
funds.
The real interest rate rises.
Private saving increases.
Investment decreases.

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 Government in the Market for
Loanable Funds
Figure 7.9 illustrates the
Ricardo-Barro effect.
A budget deficit increases
the demand for funds.
Rational taxpayers increase
saving, which increases the
supply of funds.
Crowding-out is avoided.
Increased saving finances
the deficit.

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