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N. Gregory Mankiw
Brief Principles of
Macroeconomics
Sixth Edition
8
Saving, Investment,
and the Financial System
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Ron Cronovich
In this chapter,
look for the answers to these questions:
• What are the main types of financial institutions
in the U.S. economy, and what is their function?
• What are the three kinds of saving?
• What’s the difference between saving and
investment?
• How does the financial system coordinate saving
and investment?
• How do govt policies affect saving, investment,
and the interest rate?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Financial Institutions
 The financial system: the
group of institutions that
helps match the saving of
one person with the
investment of another.
 Financial markets:
institutions through which
savers can directly provide
funds to borrowers.
Examples:
 The Bond Market.
A bond is a certificate of
indebtedness.
 The Stock Market.
A stock is a claim to
partial ownership in a
firm.
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2
Bond Market
http://www.youtube.com/user/etrade#p/c/EDA5E6EEB6E
F39B6/12/VFK30CspfJM
Bonds = IOU. The bond identifies the
time at which the loan will be
repaid (called “date of maturity”).
The Bond holders give there
money to Company/Government
in exchange for a promise of
repayment of principal plus
interest.
• Sale of bond to raise money =
debt finance
• Length of time = Term
• Never mature = Perpetuity
• Probability that the borrower
will default = Credit Risk
• High Risk Corporations =
Junk Bonds
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3
Stock Market
 Stocks = Represents
ownership in a company. After
a corporation sells shares to
the public, these shares trade
among stockholders on
organized stock exchanges
(markets). Compared to
bonds, stocks offer higher risk
and potentially higher returns.
 In US – major exchanges
= NYSE, American stock
exchange, and the
NASDAQ.
 Sale of a stock to raise
money = equity finance
 Avg. prices of groups of
stocks = stock index
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4
Financial Institutions
 Financial intermediaries:
institutions through which
savers can indirectly
provide funds to
borrowers. Examples:
 Banks
 Mutual funds –
institutions that sell
shares to the public and
use the proceeds to buy
portfolios of stocks and
bonds
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5
Quick Quiz
 What is a Stock?
 What is a Bond?
 How are they Different? Same?
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6
The Financial Crisis of 2008–2009
http://abcnews.go.com/Business/fullpage?id=9549471
 A financial crisis led to a deep recession in the U.S.
and around the world. A few unemployment rates:
11
10
8
7
6
5
4
USA
France
U.K.
Canada
Sweden
3
12-2007
01-2008
02-2008
03-2008
04-2008
05-2008
06-2008
07-2008
07-2008
08-2008
09-2008
10-2008
11-2008
12-2008
01-2009
02-2009
03-2009
04-2009
05-2009
06-2009
07-2009
08-2009
09-2009
10-2009
11-2009
12-2009
% of labor force
9
FYI: Elements of Financial Crises
 Large decline in some asset prices
 2008–2009: Housing prices fell 30%.
 Insolvencies at financial institutions
 2008–2009:
Banks and other institutions failed when many
homeowners stopped paying their mortgages.
 Decline in confidence in financial institutions
 2008–2009:
Customers with uninsured deposits began
pulling their funds out of financial institutions.
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8
FYI: Elements of Financial Crises
 Credit crunch
 2008–2009: Borrowers unable to get loans
because troubled lenders not confident in
borrowers’ credit-worthiness.
 Economic downturn
 2008–2009: Failing financial institutions and a
fall in investment caused GDP to fall and
unemployment to rise.
 Vicious circle
 2008–2009: The downturn reduced profits and
asset values, which worsened the crisis.
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9
To simplify – book uses closed economy
 Closed Economy does not
interact with other
economies
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10
Different Kinds of Saving
Recall: Y=C+I+G+NX
Y=GDP C=Consumption I=Investment G=Gov’t Purchases NX=Net Exports
(exports-imports)
 In a CLOSED Economy: Y=C+I+G
To see what this can tell us about financial markets, we must
subtract C and G from both sides:
Thus: Y – C – G = I
 Y-C-G is the total income in the economy that remains after
paying consumption and gov’t purchases – this amount is called
national savings, or just savings.
Notice that Savings=Investment
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11
Different Kinds of Saving
T=Government collected Taxes minus transfer payments (SS, Welfare, etc)
Private saving - The amount of income that households have left after
paying taxes and consumption.
= The portion of households’ income that is not used for
consumption or paying taxes
=Y–T–C
Public saving – The amount of tax revenue that the gov’t has left after
paying for its spending.
= Tax revenue less government spending
=T–G
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12
National Saving
National saving
= private saving + public saving
=
=
(Y – T – C) +
(T – G)
Y – C – G
= the portion of national income that is not used
for consumption or government purchases
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13
Saving and Investment
Recall the national income accounting identity:
Y = C + I + G + NX
For the rest of this chapter, focus on the closed
economy case:
Y=C+I+G
national saving
Solve for I:
I = Y–C–G
= (Y – T – C) + (T – G)
Saving = investment in a closed economy
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14
Budget Deficits and Surpluses
Budget surplus – An excess of tax revenue over government spending.
= If T exceeds G
= T–G
= public saving
Budget deficit – A shortfall of tax revenue from gov’t spending.
= If G is larger than T
= G–T
= – (public saving)
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15
ACTIVE LEARNING
A. Calculations
1
 Suppose GDP equals $10 trillion,
consumption equals $6.5 trillion,
the government spends $2 trillion
and has a budget deficit of $300 billion.
 First Define (Use Equations): public saving,
taxes, private saving, national saving, and
investment.
 Find public saving, taxes, private saving,
national saving, and investment.
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ACTIVE LEARNING
Answers, part A
Given:
Y = 10.0,
1
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
1
B. How a tax cut affects saving
 Use the numbers from the preceding exercise,
but suppose now that the government cuts taxes
by $200 billion.
 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
1
In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged,
so investment is unchanged.
2. If consumers save $50 billion and spend $150
billion, then national saving and investment
each fall by $150 billion.
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ACTIVE LEARNING
1
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 Meaning of Saving and Investment
 Private saving is the income remaining after
households pay their taxes and pay for
consumption.
 Examples of what households do with saving:
 Buy corporate bonds or equities
 Purchase a certificate of deposit at the bank
 Buy shares of a mutual fund
 Let accumulate in saving or checking accounts
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21
The Meaning of Saving and Investment
 Investment is the purchase of new capital.
 Examples of investment:
 General Motors spends $250 million to build
a new factory in Flint, Michigan.
 You buy $5000 worth of computer equipment
for your business.
 Your parents spend $300,000 to have a new
house built.
Remember: In economics, investment is NOT
the purchase of stocks and bonds!
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22
The Market for Loanable Funds
 A supply–demand model of the
financial system
 Helps us understand
 how the financial system
coordinates
saving & investment
 how govt policies and other
factors affect saving,
investment, the interest rate
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23
The Market for Loanable Funds
Assume: only one financial market
 All savers deposit their saving in this market.
 All borrowers take out loans from this market.
 There is one interest rate, which is both the
return to saving and the cost of borrowing.
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24
The Market for Loanable Funds
The supply of loanable funds comes from saving:
 Households with extra income can loan it out
and earn interest.
 Public saving, if positive, adds to national
saving and the supply of loanable funds.
If negative, it reduces national saving and the
supply of loanable funds.
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25
The Slope of the Supply Curve
Interest
Rate
Supply
6%
3%
60
80
An increase in
the interest rate
makes saving
more attractive,
which increases
the quantity of
loanable funds
supplied.
Loanable Funds
($billions)
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26
The Market for Loanable Funds
The demand for loanable funds comes from
investment:
 Firms borrow the funds they need to pay for
new equipment, factories, etc.
 Households borrow the funds they need to
purchase new houses.
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27
The Slope of the Demand Curve
A fall in the interest
rate reduces the cost
of borrowing, which
increases the quantity
of loanable funds
demanded.
Interest
Rate
7%
4%
Demand
50
80
Loanable Funds
($billions)
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28
Equilibrium
Interest
Rate
Supply
The interest rate
adjusts to equate
supply and demand.
The eq’m quantity
of L.F. equals
eq’m investment
and eq’m saving.
5%
Demand
60
Loanable Funds
($billions)
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29
Policy 1: Saving Incentives
Interest
Rate
S1
S2
5%
4%
D1
60 70
Tax incentives for
saving increase
the supply of L.F.
…which reduces the
eq’m interest rate
and increases the
eq’m quantity of L.F.
Loanable Funds
($billions)
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30
Policy 2: Investment Incentives
Interest
Rate
An investment tax
credit increases the
demand for L.F.
S1
6%
5%
D2
…which raises the
eq’m interest rate
and increases the
eq’m quantity of L.F.
D1
60 70
Loanable Funds
($billions)
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31
ACTIVE LEARNING
Budget deficits
2
 Use the loanable funds model to analyze
the effects of a government budget deficit:
 Draw the diagram showing the initial
equilibrium.
 Determine which curve shifts when the
government runs a budget deficit.
 Draw the new curve on your diagram.
 What happens to the equilibrium values of the
interest rate and investment?
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ACTIVE LEARNING
Answers
Interest
Rate
S2
2
S1
A budget deficit reduces
national saving and the
supply of L.F.
…which increases the
eq’m interest rate
and decreases the
eq’m quantity of L.F.
and investment.
6%
5%
D1
50 60
Loanable Funds
($billions)
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Budget Deficits, Crowding Out,
and Long-Run Growth
 Our analysis: Increase in budget deficit causes
fall in investment.
The govt borrows to finance its deficit,
leaving less funds available for investment.
 This is called crowding out.
 Recall from the preceding chapter: Investment
is important for long-run economic growth.
Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
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34
The U.S. Government Debt
 The government finances deficits by borrowing
(selling government bonds).
 Persistent deficits lead to a rising govt debt.
 The ratio of govt debt to GDP is a useful
measure of the government’s indebtedness
relative to its ability to raise tax revenue.
 Historically, the debt-GDP ratio usually rises
during wartime and falls during peacetime—until
the early 1980s.
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35
U.S. Government Debt
as a Percentage of GDP, 1970–2010
120%
WW2
100%
63.6% in
2010
80%
60%
Revolutionary
War
Civil
War
WW1
40%
20%
0%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
CONCLUSION
 Like many other markets, financial markets are
governed by the forces of supply and demand.
 One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
Financial markets help allocate the economy’s
scarce resources to their most efficient uses.
 Financial markets also link the present to the future:
They enable savers to convert current income into
future purchasing power, and borrowers to acquire
capital to produce goods and services in the future.
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37
S U MMA RY
• The U.S. financial system is made up of many
types of financial institutions, like the stock and
bond markets, banks, and mutual funds.
• National saving equals private saving plus
public saving.
• In a closed economy, national saving equals
investment. The financial system makes this
happen.
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S U MMA RY
• The supply of loanable funds comes from
saving. The demand for funds comes from
investment. The interest rate adjusts to balance
supply and demand in the loanable funds
market.
• A government budget deficit is negative public
saving, so it reduces national saving, the supply
of funds available to finance investment.
• When a budget deficit crowds out investment,
it reduces the growth of productivity and GDP.
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