WHAT’S NEW IN THE EIGHTH EDITION:
There is a new Ask the Experts feature on “Fiscal Policy and Saving.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
some of the important nancial institutions in the U.S. economy.
how the nancial system is related to key macroeconomic variables.
the model of the supply and demand for loanable funds in nancial markets.
how to use the loanable-funds model to analyze various government policies.
how government budget decits a#ect the U.S. economy.
CONTEXT AND PURPOSE:
Chapter 26 is the second chapter in a four-chapter sequence on the production of output in
the long run. In Chapter 25, we found that capital and labor are among the primary
determinants of output. For this reason, Chapter 26 addresses the market for saving and
investment in capital, and Chapter 27 addresses the tools people and rms use when
choosing capital projects in which to invest. Chapter 28 will address the market for labor.
The purpose of Chapter 26 is to show how saving and investment are coordinated by the
loanable funds market. Within the framework of the loanable funds market, we are able to
see the e#ects of taxes and government decits on saving, investment, the accumulation of
capital, and ultimately, the growth rate of output.
KEY POINTS:
The U.S. nancial system is made up of many types of nancial institutions, such as the
bond market, the stock market, banks, and mutual funds. All of these institutions act to
direct the resources of households that want to save some of their income into the hands
of households and rms who want to borrow.
National income accounting identities reveal some important relationships among
macroeconomic variables. In particular, for a closed economy, national saving must
423
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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26 SAVING, INVESTMENT,
AND THE FINANCIAL
SYSTEM
424 ❖ Chapter 26/Saving, Investment, and the Financial System
equal investment. Financial institutions are the mechanism through which the economy
matches one person’s saving with another person’s investment.
The interest rate is determined by the supply and demand for loanable funds. The supply
of loanable funds comes from households who want to save some of their income and
lend it out. The demand for loanable funds comes from households and rms who want
to borrow for investment. To analyze how any policy or event a#ects the interest rate,
one must consider how it a#ects the supply and demand for loanable funds.
National saving equals private saving plus public saving. A government budget decit
represents negative public saving and, therefore, reduces national saving and the supply
of loanable funds available to nance investment. When a government budget decit
crowds out investment, it reduces the growth of productivity and GDP.
CHAPTER OUTLINE:
I. Denition of +nancial system: the group of institutions in the economy that help
to match one person’s saving with another person’s investment.
II. Financial Institutions in the U.S. Economy
A. Financial Markets
1. Denition of +nancial markets: +nancial institutions through which savers
can directly provide funds to borrowers.
2. The Bond Market
a. Denition of bond: a certi+cate of indebtedness.
b. A bond identies the date of maturity and the rate of interest that will be paid
periodically until the loan matures.
c. One important characteristic that determines a bond’s value is its term. The
term is the length of time until the bond matures. All else being equal,
long-term bonds pay higher rates of interest than short-term bonds.
d. Another important characteristic of a bond is its credit risk, which is the
probability that the borrower will fail to pay some of the interest or principal.
All else being equal, the more risky a bond is, the higher its interest rate.
e. A third important characteristic of a bond is its tax treatment. For example,
when state and local governments issue bonds (called municipal bonds), the
interest income earned by the holders of these bonds is not taxed by the
federal government. This makes the bonds more attractive, lowering the
interest rate needed to entice people to buy them.
3. The Stock Market
a. Denition of stock: a claim to partial ownership in a +rm.
b. The sale of stock to raise money is called equity nance; the sale of bonds to
raise money is called debt nance.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Chapter 26/Saving, Investment, and the Financial System ❖ 425
c. Stocks are sold on organized stock exchanges (such as the New York Stock
Exchange or NASDAQ) and the prices of stocks are determined by supply and
demand.
d. The price of a stock generally reJects the perception of a company’s future
protability.
e. A stock index is computed as an average of a group of stock prices.
f. FYI: Key Numbers for Stock Watchers describes three key numbers that are
reported on the nancial pages.
B. Financial Intermediaries
1. Denition of +nancial intermediaries: +nancial institutions through which
savers can indirectly provide funds to borrowers.
2. Banks
a. The primary role of banks is to take in deposits from people who want to save
and then lend them out to others who want to borrow.
b. Banks pay depositors interest on their deposits and charge borrowers a
slightly higher rate of interest to cover the costs of running the bank and
provide the bank owners with some amount of prot.
c. Banks also play another important role in the economy by allowing individuals
to use checking deposits as a medium of exchange.
3. Mutual Funds
a. Denition of mutual fund: an institution that sells shares to the public
and uses the proceeds to buy a portfolio of stocks and bonds.
b. The primary advantage of a mutual fund is that it allows individuals with small
amounts of money to diversify.
c. Mutual funds called “index funds” buy all of the stocks of a given stock index.
These funds have generally performed better than funds with active fund
managers. This may be true because they trade stocks less frequently and
they do not have to pay the salaries of fund managers.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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 or school-approved learning management system for classroom use.
426 ❖ Chapter 26/Saving, Investment, and the Financial System
Activity 1—Create a Portfolio
Type: Take-home assignment
Topics: Financial markets
Class limitations: Works in any size class
Purpose
This assignment requires students to use the nancial pages of the newspaper to
create their own portfolio. Many students are unfamiliar with the basic elements of
stock and bond tables. This assignment then asks students to analyze elements
that would a#ect their portfolio.
Instructions
Ask the students to do the following assignment. Many possible variations exist. It
can be worthwhile to have students reevaluate their portfolio at the end of the
semester.
1. Assume you have $100,000 in savings. Create a portfolio of securities worth
$100,000. Decide what nancial instruments you would like to use, then nd
their current prices in the newspaper. 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?
3. Explain how each of the following economic events would a#ect the value of
your portfolio:
a. an increase or decrease in interest rates
b. a recession
c. rapid inJation
d. a depreciation of the U.S. dollar
Common Answers and Points for Discussion
Most students pick a mix of common stocks, mutual funds, and bonds. Some
choose familiar, low-risk, but low-yielding bank accounts and certicates of
deposit. A few may choose more sophisticated nancial instruments.
This can be used to introduce the trade-o# between risk and return and the
concept of the risk premium.
The impact of macroeconomic events on nancial markets usually interests
students. Portfolios heavily invested in cyclical stocks will give low returns in the
event of recession.
Bonds and cash perform poorly with unanticipated inJation. Foreign-denominated
C. Summing Up
1. There are many nancial institutions in the U.S. economy.
2. These institutions all serve the same goal—moving funds from savers to
borrowers.
III. Saving and Investment in the National Income Accounts
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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 or school-approved learning management system for classroom use.
Make sure that you work through all of the algebraic steps here. Students
will not understand this material if you skip steps.
Chapter 26/Saving, Investment, and the Financial System ❖ 427
A. Some Important Identities
1. Remember that GDP can be divided up into four components: consumption,
investment, government purchases, and net exports.
2. We will assume that we are dealing with a closed economy (an economy that
does not engage in international trade or international borrowing and lending).
This implies that GDP can now be divided into only three components:
3. To isolate investment, we can subtract C and G from both sides:
4. The left-hand side of this equation (Y – C – G ) is the total income in the economy
after paying for consumption and government purchases. This amount is called
national saving.
5. Denition of national saving (saving): the total income in the economy
that remains after paying for consumption and government purchases.
6. Substituting saving (S) into our identity gives us:
7. This equation tells us that saving equals investment.
8. Let’s go back to our denition of national saving once again:
9. We can add taxes (T) and subtract taxes (T):
10. The rst part of this equation (Y – T – C ) is called private saving; the second part
(T – G ) is called public saving.
a. Denition of private saving: the income that households have left after
paying for taxes and consumption.
b. Denition of public saving: the tax revenue that the government has
left after paying for its spending.
c. Denition of budget surplus: an excess of tax revenue over
government spending.
d. Denition of budget de+cit: a shortfall of tax revenue from
government spending.
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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 or school-approved learning management system for classroom use.
Y C I G NX= + + +
Y C I G= + +
Y C G I– – =
S I=
S Y C G= – –
( ) ( )S Y C T T G= – – + –
428 ❖ Chapter 26/Saving, Investment, and the Financial System
11. The fact that S = I means that (for the economy as a whole) saving must be equal
to investment.
a. The bond market, the stock market, banks, mutual funds, and other nancial
markets and institutions stand between the two sides of the S = I equation.
b. These markets and institutions take in the nation’s saving and direct it to the
nation’s investment.
B. The Meaning of Saving and Investment
1. In macroeconomics, investment refers to the purchase of new capital, such as
equipment or buildings.
2. If an individual spends less than he earns and uses the rest to buy stocks or
mutual funds, economists call this saving.
IV. The Market for Loanable Funds
A. Denition of 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.
B. Supply and Demand for Loanable Funds
1. The supply of loanable funds comes from those who spend less than they earn.
The supply can occur directly through the purchase of some stock or bonds or
indirectly through a nancial intermediary.
2. The demand for loanable funds comes from households and rms who wish to
borrow funds to make investments. Families generally invest in new homes while
rms may borrow to purchase new equipment or to build factories.
3. The price of a loan is the interest rate.
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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 or school-approved learning management system for classroom use.
Students will wonder which interest rate is the price of a loan. Explain to
them that interest rates in the economy do vary because of the things
discussed earlier (term, risk, and tax treatment), but that these interest
rates tend to move together when changes in the loanable funds market
occur. Thus, it is appropriate to talk of one interest rate.
The important point to make here is that with a government budget
decit, public saving is negative and the public sector is thus “dissaving.”
To make up for this shortfall, it must go to the loanable funds market and
borrow the money. This will reduce the supply of loanable funds available
for investment.
You will have to keep reminding students what the term “investment”
means to economists. Outside of the economics profession, most people
use the terms “saving” and “investing” interchangeably.
Chapter 26/Saving, Investment, and the Financial System ❖ 429
a. All else equal, as the interest rate rises, the quantity of loanable funds
supplied will increase.
b. All else equal, as the interest rate rises, the quantity of loanable funds
demanded will fall.
4. At equilibrium, the quantity of funds demanded is equal to the quantity of funds
supplied.
a. If the interest rate in the market is greater than the equilibrium rate, the
quantity of funds demanded would be smaller than the quantity of funds
supplied. Lenders would compete for borrowers, driving the interest rate
down.
b. If the interest rate in the market is less than the equilibrium rate, the quantity
of funds demanded would be greater than the quantity of funds supplied. The
shortage of loanable funds would encourage lenders to raise the interest rate
they charge.
5. The supply and demand for loanable funds depends on the real (rather than
nominal) interest rate because the real rate reJects the true return to saving and
the true cost of borrowing.
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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 or school-approved learning management system for classroom use.
It is a good idea to remind students that the supply of loanable funds
comes from saving and the demand for loanable funds comes from
investment by putting “(saving)” next to the supply curve and
“(investment)” next to the demand curve as shown above.
When examining the next three sections on di#erent policies, encourage
students to follow the three-step process developed in Chapter 4. First,
determine which curve is a#ected. Then, decide which way it shifts to
determine the e#ects on the equilibrium interest rate and quantity of
funds.
Make sure that you spend time discussing why the demand for loanable
funds is downward sloping and why the supply of loanable funds is upward
sloping. It is important for students to understand the relationships among
the interest rate, saving, and investment.
Figure 1
430 ❖ Chapter 26/Saving, Investment, and the Financial System
C. Policy 1: Saving Incentives
1. Many economists and policymakers have advocated increases in how much
people save.
2. Suppose that the government changes the tax code to encourage greater saving.
a. This will cause an increase in saving, shifting the supply of loanable funds to
the right.
b. The equilibrium interest rate will fall and the equilibrium quantity of funds will
rise.
3. Thus, the result of the new tax laws would be a decrease in the equilibrium
interest rate and greater saving and investment.
D. Policy 2: Investment Incentives
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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 or school-approved learning management system for classroom use.
If you would like, now would be a good time to discuss the debate in
Chapter 23 concerning whether the tax laws should be reformed to
encourage saving.
Figure 2
Figure 3
Chapter 26/Saving, Investment, and the Financial System ❖ 431
1. Suppose instead that the government passed a new law lowering taxes for any
rm building a new factory or buying a new piece of equipment (through the use
of an investment tax credit).
a. This will cause an increase in investment, causing the demand for loanable
funds to shift to the right.
b. The equilibrium interest rate will rise, and the equilibrium quantity of funds
will increase as well.
2. Thus, the result of the new tax laws would be an increase in the equilibrium
interest rate and greater saving and investment.
E. Policy 3: Government Budget Decits and Surpluses
1. A budget decit occurs if the government spends more than it receives in tax
revenue.
2. This implies that public saving (T – G) falls, which will lower national saving.
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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 or school-approved learning management system for classroom use.
Point out that both Policy 1 (a law to increase saving) and Policy 2 (a law
to increase investment) each lead to an increase in both saving and
investment. The di#erence between these two policies lies in their e#ects
on the interest rate.
Figure 4
432 ❖ Chapter 26/Saving, Investment, and the Financial System
a. The supply of loanable funds will shift to the left.
b. The equilibrium interest rate will rise, and the equilibrium quantity of funds
will decrease.
3. When the interest rate rises, the quantity of funds demanded for investment
purposes falls.
4. Denition of crowding out: a decrease in investment that results from
government borrowing.
5. When the government reduces national saving by running a budget decit, the
interest rate rises and investment falls.
6. A budget decit resulting from a tax cut has similar e#ects. A tax cut reduces
public saving. Private saving rises by less than public saving declines. Once again,
the budget decit reduces the supply of loanable funds.
7. Government budget surpluses work in the opposite way. The supply of loanable
funds increases, the equilibrium interest rate falls, and investment rises.
8. Ask the Experts: Fiscal Policy and Saving
a. 79 percent of economic experts agree that continuing to use tax and spending
policies that increase consumption but decrease the saving rate are likely to
lead to lower long-run living standards, while the remaining 21 percent are
uncertain.
9. Case Study: The History of U.S. Government Debt
a. Figure 5 shows the debt of the U.S. government expressed as a percentage of
GDP.
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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 or school-approved learning management system for classroom use.
Now might be a good time to move to the section in Chapter 23
concerning the debate on whether or not the government should balance
its budget.
Figure 5
Chapter 26/Saving, Investment, and the Financial System ❖ 433
b. Throughout history, the primary cause of Juctuations in government debt has
been wars. However, the U.S. debt also increased substantially during the
1980s when taxes were cut but government spending was not.
c. By the late 1990s, the debt-to-GDP ratio began declining due to budget
surpluses.
d. The debt-to-GDP ratio began rising again during the rst few years of the
George W. Bush presidency. The causes have been threefold: tax cuts, a
recession, and an increase in government spending for the war on terrorism.
e. A very large increase in the debt-to-GDP ratio started occurring in 2008
because of the nancial crisis and the deep economic contraction.
f. After 2012, budget decits shrank and increases in the debt-to-GDP ratio
became smaller.
G. FYI: Financial Crises
1. What are the key elements of a nancial crisis?
a. A large decline in asset prices.
b. Insolvencies at some nancial institutions.
c. A decline in condence in nancial institutions.
d. A credit crunch.
e. An economic downturn.
f. A vicious circle.
2. Financial crises do have serious consequences but eventually end.
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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 or school-approved learning management system for classroom use.