1. Savings, Investment Spending, and the Financial System
CHAPTER 26
Savings, Investment Spending, and the Financial System

2. Matching Up Savings and Investment Spending
Savings–investment spending identity: savings and investment spending are always equal in a closed economy.
C+I+G+(X-M)+GDP
Investment spending
A budget surplus occurs when tax revenue exceeds government spending.
A budget deficit occurs when government spending exceeds tax revenue.

3. Matching Up Savings and Investment Spending
The budget balance is the difference between tax revenue and government spending.
National savings = the total amount of savings generated within the economy.
Private savings + budget balance = NS
Investment spending = National savings in a closed economy

4. A Budget Surplus
Total investment spending is assumed to be $500 billion, $400 billion of which is financed by private savings. The remaining $100 billion comes from the budget surplus.
Total investment spending is assumed to be $500 billion, $400 billion of which is financed by private savings. The remaining $100 billion comes from the budget surplus.

5. A Budget Deficit
A budget deficit of $100 billion is represented by the area below the horizontal axis. The budget deficit has absorbed part of private savings, which must now be $200 billion greater than it had been—$600 billion—in order for total savings to provide $500 billion in investment spending for this economy.
The budget deficit has absorbed part of private savings, which must now be $200 billion greater than it had been—$600 billion—in order for total savings to provide $500 billion in investment spending for this economy.

6. The Savings–Investment Spending Identity in an Open Economy
I = NS + KI (KI = capital inflow)
Investment spending = National savings + Capital inflow in an open economy
Capital inflows is investment by foreigners.
Example: Chinese have purchased US Treasury debt.
An open economy is an economy in which goods and money can flow into and out of the country.
Capital inflow is net inflow of funds into a country.
KI = IM − X (8)
Rearranging (1):
I = (GDP − C − G) + (IM − X) (9)
We can break (GDP − C − G) into private savings and the budget balance, yielding for an open economy:
I = SPrivate + SGovernment + (IM − X) = NS + KI (10)
Investment spending = National savings + Capital inflow in an open economy

8. The Market for Loanable Funds
The loanable funds market is a hypothetical market that examines the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders.
The loanable funds market does NOT actually exist. It is a simple model of a complex world of financial markets including stock, bond, bank loans, and any other market in which lending and borrowing occurs. It is the same kind of simplification that is made in other econ. models.

9. The Demand for Loanable Funds
The interest rate is the price of borrowing money.
The demand curve for loanable funds slopes downward: the lower the interest rate, the greater the quantity of loanable funds demanded.
In this example, reducing the interest rate from 12% to 4% increases the quantity of loanable funds demanded from $150 billion to $450 billion.

10. The Market for Loanable Funds
The rate of return of a project is the profit earned on the project expressed as a percentage of its cost.
If the rate of return is higher, borrowers will be willing to pay higher interest rates.

11. The Supply for Loanable Funds
The supply curve for loanable funds slopes upward: the higher the interest rate, the greater the quantity of loanable funds supplied.
In this example, increasing the interest rate from 4% to 12% increases the quantity of loanable funds supplied from $150 billion to $450 billion.

12. Equilibrium in the Loanable Funds Market
At the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Here the equilibrium interest rate is 8%, with $300 billion of funds lent and borrowed. Investment spending projects with a rate of return of 8% or higher receive financing; those with a lower rate of return do not. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted; those who demand a higher interest rate do not.

13. Savings, Investment Spending, and Government Policy – CROWDING OUT
A government must borrow if it runs a deficit, and this borrowing adds to the total demand for loanable funds. As a result, the demand curve for loanable funds shifts rightward by the amount of the government borrowing and the equilibrium moves from E1 to E2. This leads to an increase in the equilibrium interest rate from r1 to r2 and crowding out: the increase in the interest rate reduces the private quantity of loanable funds demanded from Q1 to Q2, as shown by the movement up the demand curve D1.
Quantity of private loanable funds demanded falls

14. Increasing Private Savings
Some economists have urged reforms in the tax system and adoption of other policies that would, they say, increase private savings but keep tax revenue unchanged. If they are correct, the effect would be to shift the supply curve of loanable funds to the right, leading to a reduction in the equilibrium interest rate and a larger quantity of funds lent and borrowed. Private investment spending in the economy would rise and so, ultimately, would long-run economic growth.

15. The Financial System − Definitions
A household’s wealth is the value of its accumulated savings.
Income is day-to-day earnings
A financial asset is a paper claim that entitles the buyer to future income from the seller.
A physical asset is a claim on a tangible object – a house for example.

16. The Financial System − Definitions
A liability is a requirement to pay income in the future.
Transaction costs are the expenses of negotiating and executing a deal.
Financial risk is uncertainty about future outcomes that involve financial losses and gains.
Generally, people with more money can take on more risk.
Example: playing poker with Bill Gates – is a $100 bet risky?

17. The Financial System – More Definitions
An individual can engage in diversification by investing in several different things so that the possible losses are independent events.
An asset is liquid if it can be quickly converted into cash.
An asset is illiquid if it cannot be quickly converted into cash.

18. The Financial System – More Definitions
There are four main types of financial assets:
A loan is a lending agreement between a particular lender and a particular borrower.
A bank deposit is a claim on a bank that obliges the bank to give the depositor his or her cash when demanded.
A stock represents partial ownership in a business.
A bond is a direct loan agreement (bypass banks)
Bonds do not have to be held until they mature – Bonds can be bought and sold via the bond market

19. Three Tasks of a Financial System
Reducing transaction costs─the cost of making a deal;
Reducing financial risk─uncertainty about future outcomes that involves financial gains and losses;
Providing liquid assets─assets that can be quickly converted into cash (in contrast to illiquid assets, which can’t).

20. Financial Intermediaries
A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets.
A mutual fund is a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors.
A pension fund is a type of mutual fund that holds assets in order to provide retirement income to its members.

21. Financial Intermediaries
A life insurance company sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies.
A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs of borrowers.

22. An Example of a Diversified Mutual Fund
Source: State Street Global Advisors.

23. Financial Fluctuations
Stock prices are determined by supply and demand as well as the desirability of competing assets, like bonds: when the interest rate rises, stock prices generally fall and vice versa.
Expectations drive the supply of and demand for stocks: expectations of higher future prices push today’s stock prices higher and expectations of lower future prices drive them lower.

24. Financial Fluctuations
Efficient markets hypothesis holds that the prices of financial assets embody all publicly available information. The current price is always the fair market value price.
A random walk implies just the opposite – prices vary because investors and traders act irrationally. The current stock price doesn’t represent the actual value of the shares.
Irrational investors – actions based on fear or greed.

25. The End of Chapter 26