Saving, Investment, and the Financial System What can you do with your money?

Simple Circular Flow Diagram NOTE--There are only two actors in this simple model: Households, and Firms All money spent by one actor increases the income of the other actor. Therefore… Total Income = Total Spending What choices do you have with your income? Consume or Save Total Income = C + S What choices do these actors have with their Spending? Consumer spending or Investment Total Spending = C + I Total Income = C + S = Total Spending = C + I Simplified: C + S = C + I S = I (Savings/Investment Identity)

Expanded Circular Flow Diagram NOTE--There are four actors in this model: Households, Firms, Government, and the Rest of the World. Government, with balanced budget: Tax Revenue = Government spending + transfers Budget balance = Tax Revenue – G – transfers BB can be + (surplus) or – (deficit) If S = I, now our story is: S + BB = I “National savings” Foreign Sector Capital inflow = total inflow of foreign funds – total outflow of domestic funds CI can be + (more foreign funds flowing in than domestic funds flowing out) or – (vice versa) If S + BB = I, now our story is: S + BB + CI = I

Financial System: Tasks Reducing Transaction Costs Think of Runza trying to open a new market in Minnesota and planning to build 13 new restaurants there. Cost? $7.5 million. How do they do it? Reducing Risk Mr. Runza wants to build a new Runza-baking factory. He could put up his own personal cash… but what if nobody buys more Runzas? What could he do instead? Providing liquidity a. The factory is built, but now Mr. Runza needs to buy dough, beef, cabbage and also pay his workers. He has an asset (the factory), but he can’t pay vendors/workers that way. What could he do?