SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM
Business Macroeconomics
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Saving, Investment, and the Financial
System in Macroeconomics
• The purpose of the financial system is to connect
savers and borrowers. Savers store their wealth in
ways that let them earn a return.
• Borrowers want to pursue projects, but they need
money (from savers) to fund those projects. For
example, if a firm wants to build a new factory,
they might issue bonds and stocks to savers as a
way to raise financial assets and get real assets.
• When borrowers buy those stocks and bonds, they
are effectively lending money to these firms.
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Saving, Investment, and the Financial
System
• The financial system consists of the group of
institutions in the economy that help to match
one person’s saving with another person’s
investment.
• It moves the economy’s scarce resources from
savers to borrowers.
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Key Terms
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Key Terms
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FINANCIAL INSTITUTIONS
• The financial system is made up of financial
institutions that coordinate the actions of savers
and borrowers.
• Financial institutions can be grouped into two
different categories:
– Financial markets
– Financial intermediaries
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FINANCIAL INSTITUTIONS
• Financial Markets
– Stock Market (IDX/ Bursa Efek Indonesia)
– Bond Market (Indonesian Sovereign Bond Series)
• Financial Intermediaries
– Banks
– Mutual Funds
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FINANCIAL INSTITUTIONS
• Financial markets are the institutions through
which savers can directly provide funds to
borrowers.
• Financial intermediaries are financial
institutions through which savers can indirectly
provide funds to borrowers.
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Financial Markets
• The Bond Market
• A bond is a certificate of indebtedness that specifies
obligations of the borrower to the holder of the
bond.
• Characteristics of a Bond
• Term: The length of time until the bond matures.
• Credit Risk: The probability that the borrower will fail to
pay some of the interest or principal.
• Tax Treatment: The way in which the tax laws treat the
interest on the bond.
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Financial Markets: When interest rates increase,
bond prices decrease
When interest rates go up, the price of previously issued bonds goes
down.
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Financial Markets: When interest rates increase,
bond prices decrease
Recall that one of the determinants of demand is a related good: if a
substitute is more attractive, the demand for a good will decrease.
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Financial Markets
• The Stock Market
• Shares represent a claim to partial ownership in a
firm and are therefore, a claim to the profits that the
firm makes.
• The sale of shares to raise money is called equity
financing.
• Compared to bonds, shares offer both higher risk and
potentially higher returns.
• The most important stock exchanges in Asia are
Tokyo Stock Exchange, Stock Exchange of
Singapore, and Hong Kong Stock Exchange.
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Financial Markets
• Stocks are ownership claims. When a company
initially issues stock, the company is exchanging
cash for an equal ownership stake in the company
(stocks are sometimes called “equities” because
they represent equal shares). That ownership stake
entitles the person who owns that stock to a
portion of the profit the company makes, called
dividends.
• Another source of value to someone who owns
stock is the ability to sell it to someone else, which
will yield a return to the stock owner if the stock
has appreciated.
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Financial Intermediaries
• Financial intermediaries are financial
institutions through which savers can indirectly
provide funds to borrowers.
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Financial Intermediaries
• Banks…
• take deposits from people who want to save and use
the deposits to make loans to people who want to
borrow.
• pay depositors interest on their deposits and charge
borrowers slightly higher interest on their loans.
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Financial Intermediaries
• Banks…
• help create a medium of exchange by allowing
people to write cheques against their deposits.
• A medium of exchange is an item that people can easily
use to engage in transactions.
• facilitate the purchases of goods and services.
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Financial Intermediaries
• Mutual Funds
• A mutual fund is an institution that sells shares to the
public and uses the proceeds to buy a portfolio, of
various types of shares, bonds, or both.
• Mutual funds allow people with small amounts of
money to easily diversify.
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Financial Intermediaries
• Other Financial Institutions
• Credit companies
• Pension funds
• Insurance companies
• Loan sharks
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TO NOTE:
The interest rate is the opportunity cost of
money
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SAVING AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
• Recall that GDP is both total income in an
economy and total expenditure on the
economy’s output of goods and services:
Y = C + I + G + NX
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Some Important Identities
• Assume a closed economy – one that does not
engage in international trade:
Y=C+I+G
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Some Important Identities
• Now, subtract C and G from both sides of the
equation:
Y–C–G=I
• The left side of the equation is the total income
in the economy after paying for consumption
and government purchases and is called national
saving, or just saving (S).
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Some Important Identities
• Substituting S for Y – C – G, the equation can be
written as:
S=I
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Some Important Identities
• National saving, or saving, is equal to:
S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
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The Meaning of Saving and Investment
• National Saving
• National saving is the total income in the economy
that remains after paying for consumption and
government purchases.
• Private Saving
• Private saving is the amount of income that
households have left after paying their taxes and
paying for their consumption.
• Private saving = (Y – T – C)
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The Meaning of Saving and Investment
• Public Saving
• Public saving is the amount of tax revenue that the
government has left after paying for its spending.
• Public saving = (T – G)
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To Recap:
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The Meaning of Saving and Investment
• Surplus and Deficit
• If T > G, the government runs a budget surplus
because it receives more money than it spends.
• The surplus of T - G represents public saving.
• If G > T, the government runs a budget deficit
because it spends more money than it receives in tax
revenue.
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The Meaning of Saving and Investment
• For the economy as a whole, saving must be
equal to investment.
S=I
Why? At this point it will leads to supply and
demand
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THE MARKET FOR LOANABLE
FUNDS
• Financial markets coordinate the economy’s
saving and investment in the market for
loanable funds.
• The market for loanable funds is the market in
which those who want to save supply funds and
those who want to borrow to invest demand
funds.
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Supply and Demand for Loanable Funds
• Loanable funds refers to all income that people
have chosen to save and lend out, rather than
use for their own consumption.
• The supply of loanable funds comes from
people who have extra income they want to save
and lend out.
• The demand for loanable funds comes from
households and firms that wish to borrow to
make investments.
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Supply and Demand for Loanable Funds
• Interest rate
• the price of the loan
• the amount that borrowers pay for loans and the
amount that lenders receive on their saving
• in the market for loanable funds, the real interest
rate.
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Supply and Demand for Loanable Funds
• Financial markets work much like other markets
in the economy.
• The equilibrium of the supply and demand for
loanable funds determines the real interest rate.
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Interest
Rate Supply
5%
Demand
0 $1,200 Loanable Funds
(in billions of dollars)
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0
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0
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Supply and Demand for Loanable Funds
• Government Policies That Affect Saving and
Investment
• Taxes and saving
• Taxes and investment
• Government budget deficits and surpluses
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Policy 1: Saving Incentives
• Taxes on interest income substantially reduce
the future payoff from current saving and, as a
result, reduce the incentive to save.
• A tax decrease increases the incentive for
households to save at any given interest rate.
• The supply of loanable funds curve shifts right.
• The equilibrium interest rate decreases.
• The quantity demanded for loanable funds increases.
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Interest Supply, S1 S2
Rate
1. Tax incentives for
5%
saving increase the
supply of loanable
4%
funds . . .
2. . . . which Demand
reduces the
equilibrium
interest rate . . .
0 $1,200 $1,600 Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
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Policy 1: Saving Incentives
• If a change in tax law encourages greater saving,
the result will be lower interest rates and greater
investment.
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Policy 2: Investment Incentives
• An investment tax credit increases the incentive
to borrow.
• Increases the demand for loanable funds.
• Shifts the demand curve to the right.
• Results in a higher interest rate and a greater
quantity saved.
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Policy 2: Investment Incentives
• If a change in tax laws encourages greater
investment, the result will be higher interest
rates and greater saving.
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Interest
Rate Supply
1. An investment
tax credit
6% increases the
demand for
5% loanable funds . . .
2. . . . which
raises the D2
equilibrium
interest rate . . . Demand, D1
0 $1,200 $1,400 Loanable Funds
(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
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Policy 3: Government Budget Deficits and
Surpluses
• When the government spends more than it
receives in tax revenues, the short fall is called
the budget deficit.
• The accumulation of past budget deficits is
called the government debt.
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Policy 3: Government Budget Deficits and
Surpluses
• Government borrowing to finance its budget
deficit reduces the supply of loanable funds
available to finance investment by households
and firms.
• This fall in investment is referred to as crowding
out.
• The deficit borrowing crowds out private borrowers
who are trying to finance investments.
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Policy 3: Government Budget Deficits and
Surpluses
• A budget deficit decreases the supply of
loanable funds.
• Shifts the supply curve to the left.
• Increases the equilibrium interest rate.
• Reduces the equilibrium quantity of loanable
funds.
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Interest S2
Rate Supply, S1
1. A budget deficit
6%
decreases the
5% supply of loanable
funds . . .
2. . . . which
raises the
equilibrium Demand
interest rate . . .
0 $800 $1,200 Loanable Funds
(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.
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Policy 3: Government Budget Deficits and
Surpluses
• When government reduces national saving by
running a deficit, the interest rate rises and
investment falls.
• A budget surplus increases the supply of
loanable funds, reduces the interest rate, and
stimulates investment.
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More on Next Week
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Summary
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