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Saving, Investment, and the Financial System Module 22 Saving and Investment in the National Income Accounts Recall that GDP is both total income (Y) in an economy and total expenditure (C+I+G+NX) on the economy’s output of goods and services: Y = C + I + G + NX Saving-Investment Identity Assume a closed economy (one that does not engage in international trade) and one without government involvement: Total income = Total spending Y=C+I Saving-Investment Identity • Remember you can do two things with your income: save it or spend it Y = Consumption + Savings C+S=C+I Saving-Investment Identity • Removing Consumption from both sides reveals that for the economy as a whole, the money that is available for businesses to borrow in order to buy capital (investment) is our savings. S=I Adding Government to Equation • Government spends on goods, services and transfer payments and collects tax revenue to pay for these things • If the government budget is balanced Tax Revenue = Government Spending Budget Balance (BB) = Tax Revenue – Government Spending Saving-Investment Identity • If BB > 0, the government has a budget surplus and is SAVING money • If BB < 0, the government has a budget deficit and is BORROWING money • Adding government saving (public saving) to private saving equals national savings S + BB = I Private savings + Public savings = Investment • If government has a surplus I will increase • If government has a deficit I will decrease Adding Foreign Sector • An American can save in the US or in a foreign country and a foreign citizen can save in their country or in the US • The US receives inflows of funds--foreign savings that finance Investment spending • The US also generates outflows of funds-US savings that finance foreign Investment spending Saving-Investment Identity Capital Inflow into the US = total inflow of foreign funds – total outflow of domestic funds to other countries • Capital inflows can be positive or negative This leads to: S + BB + CI = I If CI > 0 then Investment must increase If CI < 0 then Investment must decrease The Loanable Funds Market Chapter 13 The Market for Loanable Funds •Financial markets coordinate the economy’s saving and investment in the market 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. Supply and Demand for Loanable Funds • The supply of loanable funds comes from people who have extra income they want to save and lend out (savings). • The demand for loanable funds comes from households and firms that wish to borrow to make investments (borrowing) . Market for Loanable Funds... Real Interest Rate Supply (savings) 4% Demand (borrowing) 0 $1,000 Loanable Funds (in billions of dollars) Supply and Demand for Loanable Funds The interest rate is the price of the loan. • It represents the amount that borrowers pay for loans and the amount that lenders (savers) receive on their saving. • As interest rates rise savers will be more willing to save and vice versa. • As interest rates fall borrowers will be more willing to borrow and vice versa. • Market for Loanable Funds Real Interest Rates 6% Quantity of loanable funds supplied 1400 Quantity of loanable funds demanded 600 5% 1200 800 4% 1000 1000 3% 800 1200 2% 600 1400 Interest Rates and the Loanable Funds Market • • The interest rate in the market for loanable funds is the real interest rate. The equilibrium of the supply and demand for loanable funds determines the real interest rate Market for Loanable Funds... Real Interest Rate Supply (savings) 4% Demand (borrowing) 0 $1,000 Loanable Funds (in billions of dollars) An Increase in the Supply of Loanable Funds • Households decide to save more of their income which – Reduces the equilibrium interest rate and – Raises the equilibrium quantity of loanable funds Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Supply of Loanable Funds... Interest Rate Supply, S1 S2 1. Households decide to save more of their income. 4% 3% Demand 2. ...which reduces the equilibrium interest rate... 0 $1,000 Loanable Funds $1,200 (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. An Increase in the Demand for Loanable Funds • Businesses decide to now is a good time to invest in plants and equipment so they demand more loans – Increases the equilibrium interest rate and – Raises the equilibrium quantity of loanable funds Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Demand for Loanable Funds... Interest Rate 5% 4% 2. ...which raises the equilibrium interest rate... 0 Supply 1. Businesses decide now is a good time to invest in plants & equipment D2 Demand, D1 $1,200 $1,000 Loanable Funds (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. Factors that affect Supply and Demand for Loanable Funds • There are several factors that affect the supply and demand for loanable funds. Two of them are: – Taxes – Government deficits and surpluses Taxes and Saving •Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. The result will be higher interest rates and smaller investment •If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Supply of Loanable Funds... Interest Rate Supply, S1 S2 1. Households decide to save more of their income. 4% 3% Demand 2. ...which reduces the equilibrium interest rate... 0 $1,000 Loanable Funds $1,200 (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. Taxes and Investment If a change in tax laws encourages greater investment (a reduction in the capital gains tax), the result will be higher interest rates and greater saving. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. An Increase in the Demand for Loanable Funds... Interest Rate 6% 5% 2. ...which raises the equilibrium interest rate... 0 Supply 1. An investment tax credit increases the demand for loanable funds... D2 Demand, D1 $1,400 $1,200 Loanable Funds (in billions of dollars) 3. ...and raises the equilibrium quantity of loanable funds. 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. Interest rates rise and investment falls. This fall in investment is referred to as crowding out. The deficit borrowing crowds out private borrowers who are trying to finance investments. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Effect of a Government Budget Deficit... Interest Rate S2 6% 5% 2. ...which raises the equilibrium interest rate... $800 $1,200 0 3. ...and reduces the equilibrium quantity of loanable funds. Supply, S1 1. A budget deficit decreases the supply of loanable funds... Demand Loanable Funds (in billions of dollars) 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. The deficit of T-G represents a reduction in public saving