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SAVING,
INVESTMENT, AND
THE FINANCIAL
SYSTEM
Chapter 8
Copyright © 2014 by Nelson Education Ltd.
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SAVING, INVESTMENT, AND
THE FINANCIAL SYSTEM
 Financial system: the group of institutions in the
economy that help to match one person’s
savings with another person’s investment
 This chapter examines how the financial system
works.
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FINANCIAL INSTITUTIONS
IN THE CANADIAN ECONOMY
Financial institutions can be grouped into
two categories:
Financial markets
Financial intermediaries
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Financial Markets
Financial markets: financial institutions
through which savers can directly provide
funds to borrowers
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Financial Markets: The Bond Market
Bond: a certificate of indebtedness that
specifies the obligation of the borrower to the
holder of the bond
Debt finance: the sale of a bond to raise
money
Characteristics:
the bond’s term
the bond’s credit risk
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Financial Markets: The Stock Market
 Stock: represents ownership
in a firm and is, therefore, a
claim to its profits
moodboard/Thinkstock
 Equity finance: the sale of a
stock to raise money
 The prices at which shares
trade on stock exchanges
are determined by the supply
and demand for the stock.
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Financial Markets: The Stock Market
 Stock index: is an average of a group of stock
prices
 Dow Jones Industrial Average
 S&P/TSX Composite Index
 Because stock prices reflect expected
profitability, stock indexes are watched closely as
possible indicators of future economic conditions.
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Financial Intermediaries
Financial intermediaries: financial
institutions through which savers can
indirectly provide funds to borrowers
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Financial Intermediaries
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Thinkstock
Bank: The primary
function of a bank is to
take deposits from
savers and use these
deposits to make loans
to people who want
to borrow.
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Financial Intermediaries
Mutual funds: an institution that sells shares
to the public and uses the proceeds to buy
a portfolio of stocks and bonds
Allow diversification
Access to the skills of professional money
managers
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QuickQuiz
What is a stock?
What is a bond?
How are they different?
How are they similar?
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SAVING AND INVESTMENT
IN THE NATIONAL ACCOUNTS
Accounting: refers to how various numbers
are defined and added up
The national income accounts include, in
particular, GDP and many related statistics.
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Some Important Identities
In a closed economy:
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Some Important Identities
National saving (S): the total income in the
economy that remains after paying for
consumption and government purchases
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Some Important Identities
Let T denote the taxes collected by
government minus transfer payments.
National saving can then be expressed in either
of two ways:
or
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Some Important Identities
Private saving: the income that households
have left after paying for taxes and
consumption
Public saving: the tax revenue that the
government has left after paying for its spending
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Some Important Identities
Budget surplus:
Budget deficit:
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The Meaning of Saving and Investment
The terms saving and investment can
sometimes be confusing.
Although the accounting identity S = I
shows that saving and investment are equal
for the economy as a whole, this does not
have to be true for every individual
household or firm.
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QuickQuiz
Define the following:
• Private saving
• Public saving
• National saving
• National investment
How are they related?
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Active Learning
A. Calculations
 Suppose GDP equals $10 million, consumption
equals $6.5 million, the government spends $2
million and has a budget deficit of $300 million.
 Find public saving, taxes, private saving, national
saving, and investment.
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Active Learning
Answers: Part A
Given:
Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5
Investment = national saving = 1.5
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Active Learning
B. Calculations
 Use the numbers from the preceding exercise but
suppose now that the government cuts taxes
by $200 million.
 In each of the following two scenarios, determine
what happens to public saving, private saving,
national saving, and investment.
1. Consumers save the full proceeds of the tax cut.
2. Consumers save 1/4 of the tax cut and spend the
other 3/4.
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Active Learning
Answers: Part B
In both scenarios, public saving falls by $200
million, and the budget deficit rises from $300
million to $500 million.
1. If consumers save the full $200 million, national
saving is unchanged, so investment is
unchanged.
2. If consumers save $50 million and spend $150
million, then national saving and investment
each fall by $150 million.
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Active Learning
C. Discussion Questions
The two scenarios from this exercise were:
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and
spend the other 3/4.
 Which of these two scenarios do you think is
more realistic?
 Why is this question important?
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THE MARKET FOR LOANABLE FUNDS
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
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Supply and Demand for Loanable Funds
Saving is the source of supply for loanable
funds.
Investment is the source of demand for
loanable funds.
The interest rate is the price of a loan.
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FIGURE 8.1:
The Market for Loanable Funds
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Policy I: Saving Incentives
A higher saving rate could lead to a higher
rate of growth of GDP.
People respond to incentives:
Consumption taxes like the GST
RRSPs
TFSA
RESP
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FIGURE 8.2:
An Increase in the Supply of Loanable Funds
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Policy 2: Investment Incentives
An investment tax credit gives a tax
advantage to any firm building a new
factory or buying a new piece of
equipment.
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FIGURE 8.3:
An Increase in the Demand for Loanable Funds
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Policy 3: Government Budget
Deficits and Surpluses
Government debt: the sum of past budget
deficits and surpluses
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FIGURE 8.4:
The Effect of a Government Budget Deficit
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Policy 3: Government Budget
Deficits and Surpluses
Crowding out: a decrease in investment
that results from government borrowing
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FIGURE 8.5:
Federal and Provincial/Territorial Net Debt in Canada
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QuickQuiz
If more Canadians adopted a “live for
today” approach to life, how would this
affect saving, investment, and the
interest rate?
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Classroom Activity
Create a Portfolio
Assume you have $100 000 in savings. Create a portfolio of
securities worth $100 000. Decide what financial
instruments you would like to use, then find their current
prices in the newspaper.
1. Calculate your holdings of each security, based on
current prices.
2. What objectives do you have for this portfolio? Was it
chosen to maximize short-term gains, long-term
stability, or some other objective?
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Classroom Activity
Create a Portfolio
3. Explain how each of the following economic events
would affect the value of your portfolio.
A. an increase or decrease in interest rates
B. a recession
C. rapid inflation
D. a depreciation of the Canadian dollar
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THE END
Chapter 8
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