Chapter 13

Saving, Investment, and the

Financial system
Reference book-Mankiw

Sabakun Naher Shetu

Assistant Professor
Dept. of Marketing
FBS, JU
 Financial system
• the group of institutions in the economy that help to match
one person’s saving with another person’s investment.
• When a country saves a large portion of its GDP, more
resources are available for investment in capital, and higher
capital raises a country’s productivity and living standard.
 Financial Institutions
• Financial markets
“Financial institutions through which savers can directly provide
funds to borrowers.”

- The bond market [a certificate of indebtedness-debt finance]

[bond’s term, credit risk, tax treatment]
- The stock market [a claim of partial ownership in a firm -equity
finance]
 Financial intermediaries

• Financial intermediaries- financial institutions through which savers

can indirectly provide funds to borrowers.
• Banks
• Mutual funds [index funds]
[an institution that sells shares to the public and uses the proceeds
to buy a portfolio of stocks and bonds]
• [small amounts of money to diversify their holdings]
• [give ordinary people access to the skills of professional money
managers]
Saving and investment in the national
income accounts
• Y = C + I+ G+NX
• We simplify our analysis by assuming that the economy we are
examining is closed. A closed economy is one that does not interact
with other economies. In particular, a closed economy does not
engage in international trade in goods and services, nor does it
engage in international borrowing and lending.

• A closed economy does not engage in international trade, imports

and exports are exactly zero. Therefore, net exports (NX) are also
zero. We can now simplify the identity as
• Y = C + I+ G.
 CONTINUED….
• This equation states that GDP is the sum of consumption,
investment, and government purchases. Each unit of output
sold in a closed economy is consumed, invested, or bought by
the government.

• To see what this identity can tell us about financial markets,

subtract C and G from both sides of this equation. We then
obtain
• Y - C -G = I
 CONTINUED…

• The left side of this equation (Y - C -G) is the total income in

the economy that remains after paying for consumption
and government purchases: This amount is called national
saving, or just saving, and is denoted S.

• Substituting S for Y − C − G,
• we can write the last equation as
• S = I.
 CONTINUED…..

• To understand the meaning of national saving, it is helpful to

manipulate the definition a bit more.
• Let T denote the amount that the government collects from
households in taxes minus the amount it pays back to
households in the form of transfer payments (such as Social
Security and welfare).
• We can then write national saving in either of two ways:
• S =Y - C – G
OR,
• S =(Y - T - C) + (T - G).
 CONTINUED…

• These equations are the same because the two T’s in the second
equation cancel each other, but each reveals a different way of
thinking about national saving.
• In particular, the second equation separates national saving into two
pieces: private saving (Y - T -C) and public saving (T - G). Consider each
of these two pieces.
• Private saving is the amount of income that households have left after
paying their taxes and paying for their consumption. In particular,
because households receive income of Y, pay taxes of T, and spend C
on consumption, private saving is
(Y - T – C)
 CONTINUED…
• Public saving is the amount of tax revenue that the
government has left after paying for its spending. The
government receives T in tax revenue and spends G on goods
and services.
• If T exceeds G, the government runs a budget surplus because
it receives more money than it spends. This surplus of (T – G)
represents public saving.
• If the government spends more than it receives in tax revenue,
then G is larger than T. In this case, the government runs a
budget deficit, and public saving (T - G) is a negative number.
 The market for loanable funds
• the market in which those who want to save supply funds and those
who want to borrow to invest demand funds.
• To keep things simple, we assume that the economy has only one
financial market, called the market for loanable funds. All savers go
to this market to deposit their saving, and all borrowers go to this
market to take out their loans. Thus, the term loanable funds refers
to all income that people have chosen to save and lend out, rather
than use for their own consumption, and to the amount that
investors have chosen to borrow to fund new investment projects. In
the market for loanable funds, there is one interest rate, which is
both the return to saving and the cost of borrowing.
 Continued… Supply and Demand for Loanable Funds

• The supply of loanable funds comes from people who have some
extra income they want to save and lend out. This lending can occur
directly, such as when a household buys a bond from a firm, or it can
occur indirectly, such as when a household makes a deposit in a
bank, which then uses the funds to make loans. In both cases, saving
is the source of the supply of loanable funds.
• The demand for loanable funds comes from households and firms
who wish to borrow to make investments. This demand includes
families taking out mortgages to buy new homes. It also includes
firms borrowing to buy new equipment or build factories. In both
cases, investment is the source of the demand for loanable funds.
Continued…
 Continued…
• Figure 1 shows the interest rate that balances the supply and
demand for loanable funds. In the equilibrium shown, the
interest rate is 5 percent, and the quantity of loanable funds
demanded and the quantity of loanable funds supplied both
equal $1,200 billion.
• The adjustment of the interest rate to the equilibrium level
occurs for the usual reasons. If the interest rate were lower than
the equilibrium level, the quantity of loanable funds supplied
would be less than the quantity of loanable funds demanded. The
resulting shortage of loanable funds would encourage lenders to
raise the interest rate they charge.
 Continued…
• A higher interest rate would encourage saving (thereby increasing
the quantity of loanable funds supplied) and discourage borrowing
for investment (thereby decreasing the quantity of loanable funds
demanded). Conversely, if the interest rate were higher than the
equilibrium level, the quantity of loanable funds supplied would
exceed the quantity of loanable funds demanded. As lenders
compete for the scarce borrowers, interest rates would be driven
down. In this way, the interest rate approaches the equilibrium
level at which the supply and demand for loanable funds exactly
balance.
 Continued…

• The nominal interest rate is the monetary return to saving and the
monetary cost of borrowing. It is the interest rate as usually
reported. The real interest rate is the nominal interest rate
corrected for inflation; it equals the nominal interest rate minus
the inflation rate. Because inflation erodes the value of money
over time, the real interest rate more accurately reflects the real
return to saving and the real cost of borrowing. Therefore, the
supply and demand for loanable funds depend on the real (rather
than nominal) interest rate, and the equilibrium in Figure 1 should
be interpreted as determining the real interest rate in the
economy. For the rest of this chapter, when you see the term
interest rate, you should remember that we are talking about the
real interest rate.
 Policy 1: saving incentives

• People respond to incentives. Many economists have used this

principle to suggest that the low rate of saving is at least partly
attributable to tax laws that discourage saving. The government
collects revenue by taxing income, including interest and dividend
income.
• To see the effects of this policy, consider a 25-year-old who saves
$1,000 and buys a 30-year bond that pays an interest rate of 9
percent. In the absence of taxes, the $1,000 grows to $13,268 when
the individual reaches age 55. Yet if that interest is taxed at a rate of,
say, 33 percent, the after-tax interest rate is only 6 percent. In this
case, the $1,000 grows to only $5,743 over the 30 years. The tax on
interest income substantially reduces the future payoff from current
saving and, as a result, reduces the incentive for people to save.
 Continued…
• In response to this problem, some economists and lawmakers
have proposed reforming the tax code to encourage greater
saving. For example, one proposal is to expand eligibility for
special accounts, such as Individual Retirement Accounts, that
allow people to shelter some of their saving from taxation. Let’s
consider the effect of such a saving incentive on the market for
loanable funds, as illustrated in Figure 2. We analyze this policy
following our three steps.
Continued… Policy 1: saving incentives
 Continued….
First: Which curve would this policy affect?

• Because the tax change would alter the incentive for

households to save at any given interest rate, it would affect
the quantity of loanable funds supplied at each interest rate.
Thus, the supply of loanable funds would shift. The demand
for loanable funds would remain the same because the tax
change would not directly affect the amount that borrowers
want to borrow at any given interest rate.
 Continued…
Second: Which way would the supply curve shift?

• Because saving would be taxed less heavily than under

current law, households would increase their saving by
consuming a smaller fraction of their income. Households
would use this additional saving to increase their deposits in
banks or to buy more bonds. The supply of loanable funds
would increase, and the supply curve would shift to the right
from S1 to S2, as shown in Figure 2.
 Continued…
Third: We can compare the old and new equilibrium

• In the figure, the increased supply of loanable funds reduces

the interest rate from 5 percent to 4 percent. The lower
interest rate raises the quantity of loanable funds demanded
from $1,200 billion to $1,600 billion. That is, the shift in the
supply curve moves the market equilibrium along the
demand curve. With a lower cost of borrowing, households
and firms are motivated to borrow more to finance greater
investment. Thus, if a reform of the tax laws encouraged
greater saving, the result would be lower interest rates and
greater investment.
 Policy 2: Investment incentives

• Suppose that government passed a tax reform aimed at

making investment more attractive. In essence, this is what
Govt. does when it institutes an investment tax credit, which
it does from time to time. An investment tax credit gives a tax
advantage to any firm building a new factory or buying a new
piece of equipment. Let’s consider the effect of such a tax
reform on the market for loanable funds, as illustrated in
Figure 3.
Continued…. Policy 2: Investment incentives
 Continued….
First: Would the law affect supply or demand?

• Because the tax credit would reward firms that borrow and
invest in new capital, it would alter investment at any given
interest rate and, thereby, change the demand for loanable
funds. By contrast, because the tax credit would not affect
the amount that households save at any given interest rate,
it would not affect the supply of loanable funds.
 Continued…
Second: Which way would the demand curve shift?

• Because firms would have an incentive to increase

investment at any interest rate, the quantity of loanable
funds demanded would be higher at any given interest rate.
Thus, the demand curve for loanable funds would move to
the right, as shown by the shift from D1 to D2 in the figure.
 Continued…
Third: Consider how the equilibrium would change

• In Figure 3, the increased demand for loanable funds raises

the interest rate from 5 percent to 6 percent, and the higher
interest rate in turn increases the quantity of loanable funds
supplied from $1,200 billion to $1,400 billion, as households
respond by increasing the amount they save. This change in
household behavior is represented here as a movement along
the supply curve. Thus, if a reform of the tax laws encouraged
greater investment, the result would be higher interest rates
and greater saving.
 Policy 3: Government budget deficits and surpluses

• A perpetual topic of political debate is the status of the government

budget. Recall that a budget deficit is an excess of government spending
over tax revenue. Governments finance budget deficits by borrowing in
the bond market, and the accumulation of past government borrowing
is called the government debt. A budget surplus, an excess of tax
revenue over government spending, can be used to repay some of the
government debt. If government spending exactly equals tax revenue,
the government is said to have a balanced budget.
• Imagine that the government starts with a balanced budget and then,
because of an increase in government spending, starts running a budget
deficit. We can analyze the effects of the budget deficit by following our
three steps in the market for loanable funds, as illustrated in Figure 4.
 Continued….
Policy 3: Government budget deficits and surpluses
 Continued….
First: Would curve shifts when the government starts running a budget
deficit?

• Recall that national saving—the source of the supply of

loanable funds— is composed of private saving and public
saving. A change in the government budget balance represents
a change in public saving and, therefore, in the supply of
loanable funds. Because the budget deficit does not influence
the amount that households and firms want to borrow to
finance investment at any given interest rate, it does not alter
the demand for loanable funds.
 Continued…
Second: Which way does the supply curve shift?

• When the government runs a budget deficit, public saving is

negative, and this reduces national saving. In other words,
when the government borrows to finance its budget deficit,
it reduces the supply of loanable funds available to finance
investment by households and firms. Thus, a budget deficit
shifts the supply curve for loanable funds to the left from S1
to S2, as shown in Figure 4.
 Continued…
Third: We can compare old and new equilibrium

• In the figure, when the budget deficit reduces the supply of loanable
funds, the interest rate rises from 5 percent to 6 percent. This higher
interest rate then alters the behavior of the households and firms that
participate in the loan market. In particular, many demanders of
loanable funds are discouraged by the higher interest rate. Fewer
families buy new homes, and fewer firms choose to build new factories.
The fall in investment because of government borrowing is called
crowding out and is represented in Figure 4 by the movement along the
demand curve from a quantity of $1,200 billion in loanable funds to a
quantity of $800 billion. That is, when the government borrows to
finance its budget deficit, it crowds out private borrowers who are
trying to finance investment.
Continued…

• When the government reduces national saving by running a

budget deficit, the interest rate rises and investment falls.
Any Query
?!