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CHAPTER 4:
SAVING, INVESTMENT AND THE
FINANCIAL SYSTEM
Function of the Financial System
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The financial system consists of the group
of institutions in the economy that
perform the essential function of
channeling funds from economic players
that have saved surplus funds to those
that have a shortage of funds.
Promotes economic efficiency by
producing
an efficient allocation of capital, which
increases production.
Improve the well-being of consumers by
FINANCIAL INSTITUTIONS
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The financial system is made up of
financial institutions that matches savers
and borrowers.
Financial institutions can be grouped into
two different categories:
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Financial markets
Financial intermediaries
FINANCIAL INSTITUTIONS
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Financial markets are arrangements
(location or medium) where savers can
directly provide funds to borrowers.
Financial intermediaries are financial
institutions which collect funds from
savers and lend to borrowers. They
“intermediate” between savers and
borrowers.
FINANCIAL INSTITUTIONS
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Financial Markets
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Stock Market: Share of ownership in a firm.
Firms borrow money from savers who buy
their shares.
Bond Market: Debt instrument. Government
and firms issue bonds to borrow money from
savers who buy these bonds.
FINANCIAL INSTITUTIONS
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Financial Intermediaries
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Institutions that accept deposits : Banks
Investment Intermediaries: Investment Funds
(collects savings and manages a portfolio of
securities on owners’ behalf). Careful with the
“investment” word!
Contractual Savings Institutions: Life
Insurance, Fire & Casualty Insurance, Pension
Funds, Government Retirement Funds.
Financial Markets

The Bond Market
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A bond is a debt instrument that specifies
obligations of the borrower (issuer) to the
holder (owner) of the bond.
Characteristics of a Bond
Face Value: Nominal YTL value to be repaid at the
date of maturity.
 Date of Maturity: The time at which the face value
will be repaid.
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Financial Markets
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Types of Bonds:
Discount Bond: Current price is smaller than
face value, sold at a discount. Ex: Treasury
discount bond with 1000 YTL face value and
one year maturity is sold for 900 YTL. then
the interest rate will be
(1000-900) / 900 = 11.1 %
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Financial Markets
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Types of Bonds (continued):
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Coupon Bond: Issuer of this bond makes fixed
interest payments to the holder every year
until the maturity date. Ex: A coupon bond
with 1000 YTL face value, 50% coupon
rate, annual coupon payments and 5 years
maturity issued by the Treasury. The
treasury will pay you 500 YTL every year and
will pay you 1500 YTL five years later.
Financial Markets
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The Stock Market
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Stock represents a share of ownership in a
firm. A share of stock is a claim on the
earnings and assets of the corporation. Ex: If
Turkcell has 1,000,000 total shares and you
own 1 share, then you own 1/1,000,000 of
Turkcell’s assets.
Stocks pay “dividends” to the shareholders
regularly. Ex: every 6 months.
Compared to bonds, stocks offer both higher
risk and potentially higher returns. Tradeoff:
risk-return.
Financial Markets
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The Stock Market
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Both stocks and bonds are first issued in the
primary market. This is when the issuer firm
does initial public offering (IPO). After that,
stocks are traded in the secondary market.
Stock exchanges are the secondary markets.
The stock exchange in Turkey: Istanbul Stock
Exchange (ISE). In the United States: New
York Stock Exchange, the American Stock
Exchange, and NASDAQ. London, Frankfurt
and Tokyo have large stock exchanges.
Financial Intermediaries
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Financial intermediaries are financial
institutions through which savers can
indirectly provide funds to borrowers.
Why do we need intermediaries?
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Small savers cannot buy stocks or bonds, or
cannot diversify easily because of transaction
costs.
Small borrowers (firms) cannot issue stocks or
bonds, so they borrow from banks.
Intermediaries solve these problems.
Economies of scale reduces transaction costs.
Financial Intermediaries
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Banks…
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take deposits from people who want to save
and use the deposits to make loans to people
who want to borrow.
pay depositors no interest (checking
accounts) or some interest (savings accounts)
on their deposits.
charge borrowers higher interest on their
loans.
profit from the interest rate difference and
fees for liquidity services.
Financial Intermediaries

Banks provide liquidity services by…
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allowing people to purchase goods and
services using debit and credit cards. No need
to carry cash.
write checks against their checking account
deposits. More common in the US.
use internet to make purchases, money
transfers, automatic bill payments, etc.
Financial Intermediaries
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Investment (Mutual) Funds
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A mutual fund is an institution that sells
shares to the public and uses the proceeds to
buy a portfolio of various types of stocks and
bonds.
Mutual funds allow people with small amounts
of money to easily diversify. They pool
savings so that they can avoid transaction
costs: economies of scale.
SAVING AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
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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
Some Important Identities
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Assume a closed economy (as opposed to
an open economy). A closed economy
does not engage in international trade: NX
=0
Y=C+I+G
Some Important Identities
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We define national saving of an economy
as the total income in the economy that is
left after paying for consumption and
government purchases.
If we subtract C and G from total income
in the equation:
Y–C–G=I
We get national saving (S) on the left
hand side.
Some Important Identities
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Denoting saving by S, we get:
S=I
For a closed economy, saving equals
investment.
Some Important Identities
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We can divide national saving into two
parts: private saving and public saving.
Suppose T is the amount of tax revenues
collected by the government.
S=Y–C–G
We can also write:
S = (Y – T – C) + (T – G)
National S. = Private S. + Public S.
Some Important Identities
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Private Saving
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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)
Some Important Identities
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Public Saving
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Public saving is the amount of tax revenue
that the government has left after paying for
its spending.
Public saving = (T – G)
Some Important Identities
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Surplus and Deficit
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If T > G, the government runs a budget
surplus because it receives more money than
it spends.
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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. In this case public
saving is negative. This has been the case in
Turkey in most of its history.
The Meaning of Saving and
Investment
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For the (closed) economy as a whole,
saving must be equal to investment.
S=I
For economists, investment refers to
purchase of machinery, equipment and
buildings. In everyday language,
“investment” is used to describe purchases
of stocks and bonds. For us, those are
acts of saving.
THE MARKET FOR LOANABLE
FUNDS
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Financial markets coordinate the
economy’s saving and investment in the
market for loanable funds.
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The market for loanable funds is the
market in which those who save supply
funds and those who borrow demand
funds.
Interest
Rate
Figure 1 The Market for
Loanable Funds
Supply
5%
Demand
0
$1,200
Loanable Funds
(in billions of dollars)
Supply and Demand for
Loanable Funds
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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 firms and households that wish to
borrow to make investments.
Supply and Demand for
Loanable Funds
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Interest rate
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Is the price of the loan (credit)
Is the amount that borrowers pay for loans
and the amount that lenders earn on their
saving
in the market for loanable funds, we use the
real interest rate. Ignore inflation.
Supply and Demand for
Loanable Funds
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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.
Supply and Demand for
Loanable Funds
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Government Policies That Affect Saving
and Investment
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Taxes on saving (interest earnings).
Taxes on investment expenditures.
Government budget deficits and surpluses.
Policy 1: Saving Incentives
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Taxes on interest income substantially
reduce the future payoff from current
saving and, as a result, reduce the
incentive to save.
A tax cut on interest earnings increases
the incentive for households to save at
any given interest rate.
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The supply of loanable funds curve shifts
right.
The equilibrium interest rate decreases.
Amount of investment increases.
Figure 2 An Increase in the Supply of
Loanable Funds
Interest
Rate
Supply, S1
S2
1. Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
4%
2. . . . which
reduces the
equilibrium
interest rate . . .
Demand
0
$1,200
$1,600
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
Policy 1: Saving Incentives
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If a change in tax law encourages greater
saving, the result will be lower interest
rates and greater saving and investment.
Policy 2: Investment Incentives
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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 and invested.
Figure 3 Investment Incentives Increase the
Demand for Loanable Funds
Interest
Rate
Supply
1. An investment
tax credit
increases the
demand for
loanable funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
0
D2
Demand, D1
$1,200
$1,400
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
Policy 2: Investment Incentives
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If a change in tax laws encourages greater
investment, the result will be higher
interest rates and greater saving and
investment.
Policy 3: Government Budget
Deficits and Surpluses
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When the government spends more than
it receives in tax revenues, the short fall
(G - T) is called the budget deficit (flow
concept).
Government borrows to finance its deficit.
Issues and sells bonds in the bond market.
The accumulation of past budget deficits
is called the government debt (stock
concept).
Policy 3: Government Budget
Deficits and Surpluses
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Government borrowing to finance its
budget deficit reduces the supply of
loanable funds available to finance
investment by firms.
This fall in investment is referred to as
crowding out. This has been especially big
problem for Turkey.
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The deficit borrowing crowds out private
borrowers who are trying to finance
investments. Also keeps int. rate very high.
Policy 3: Government Budget
Deficits and Surpluses
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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.
Figure 4: The Effect of a Government
Budget
Deficit
Interest
S2
Rate
Supply, S1
1. A budget deficit
decreases the
supply of loanable
funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
Demand
0
$800
$1,200
3. . . . and reduces the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
Policy 3: Government Budget
Deficits and Surpluses
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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.
Figure 5 The U.S. Government Debt
Percent
of GDP
120
World War II
100
80
60
Revolutionary
War
Civil
War
World War I
40
20
0
1790
1810
1830
1850
1870
1890
1910
1930
1950
1970
1990
2010
Turkey's Foreign Debt/GNP Source: CBRT, Treasury
90,0
80,0
70,0
60,0
50,0
40,0
30,0
20,0
10,0
0,0
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004