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220
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
feature on "Should College Students Sell Equity in Themselves?"
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ some of the important financial institutions in the U.S. economy.
➢ how the financial system is related to key macroeconomic variables.
➢ the model of the supply and demand for loanable funds in financial markets.
➢ how to use the loanable-funds model to analyze various government policies.
➢ how government budget deficits affect the U.S. economy.
CONTEXT AND PURPOSE:
Chapter 13 is the second chapter in a four-chapter sequence on the production of output in the long run.
In Chapter 12, we found that capital and labor are among the primary determinants of output. For this
reason, Chapter 13 addresses the market for saving and investment in capital, and Chapter 14 addresses
the tools people and firms use when choosing capital projects in which to invest. Chapter 15 will address
the market for labor.
KEY POINTS:
• The U.S. financial system is made up of many types of financial 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 firms who want
to borrow.
13
SAVING, INVESTMENT, AND
THE FINANCIAL SYSTEM
Chapter 13/Saving, Investment, and the Financial System ❖ 221
• National income accounting identities reveal some important relationships among macroeconomic
variables. In particular, for a closed economy, national saving must 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 firms who want to borrow for investment. To analyze
how any policy or event affects the interest rate, one must consider how it affects the supply and
demand for loanable funds.
CHAPTER OUTLINE:
I. Definition of financial 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
2. The Bond Market
b. A bond identifies 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.
3. The Stock Market
a. Definition of stock: a claim to partial ownership in a firm.
222 ❖ Chapter 13/Saving, Investment, and the Financial System
b. The sale of stock to raise money is called
equity finance
; the sale of bonds to raise
money is called
debt finance
.
B. Financial Intermediaries
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.
3. Mutual Funds
a. Definition of mutual fund: an institution that sells shares to the public and uses
the proceeds to buy a portfolio of stocks and bonds.
Chapter 13/Saving, Investment, and the Financial System ❖ 223
C. Summing Up
1. There are many financial institutions in the U.S. economy.
2. These institutions all serve the same goal—moving funds from savers to borrowers.
D.
In the News: Should College Students Sell Equity in Themselves?
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 financial 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 affect 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 financial instruments you would like to use, then find 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 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 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 certificates of deposit. A few may choose more
sophisticated financial instruments.
224 ❖ Chapter 13/Saving, Investment, and the Financial System
III. Saving and Investment in the National Income Accounts
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:
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. Definition 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 definition of national saving once again:
9. We can add taxes (
T
) and subtract taxes (
T
):
Y C I G NX
= + + +
S Y C G
= − −
Make sure that you work through all of the algebraic steps here. Students will not
understand this material if you skip steps.
Chapter 13/Saving, Investment, and the Financial System ❖ 225
a. Definition of private saving: the income that households have left after paying
for taxes and consumption.
11. The fact that
S
=
I
means that (for the economy as a whole) saving must be equal to
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
B. Supply and Demand for Loanable Funds
The important point to make here is that with a government budget deficit, 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.
226 ❖ Chapter 13/Saving, Investment, and the Financial System
3. The price of a loan is the interest rate.
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.
Figure 1
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.
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.
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.
Chapter 13/Saving, Investment, and the Financial System ❖ 227
C. Policy 1: Saving Incentives
1. Savings rates in the United States are relatively low when compared with other countries
such as Japan and Germany.
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.
Figure 2
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.
When examining the next three sections on different policies, encourage students to
follow the three-step process developed in Chapter 4. First, determine which curve is
affected. Then, decide which way it shifts to determine the effects on the equilibrium
interest rate and quantity of funds.
228 ❖ Chapter 13/Saving, Investment, and the Financial System
D. Policy 2: Investment Incentives
1. Suppose instead that the government passed a new law lowering taxes for any firm 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 Deficits and Surpluses
Figure 3
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
difference between these two policies lies in their effects on the interest rate.
Chapter 13/Saving, Investment, and the Financial System ❖ 229
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.
5. When the government reduces national saving by running a budget deficit, the interest rate
rises and investment falls.
6. A budget deficit resulting from a tax cut has similar effects. A tax cut reduces public saving.
Private saving rises by less than public saving declines. Once again, the budget deficit
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.
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.
Figure 4
Figure 5
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.
230 ❖ Chapter 13/Saving, Investment, and the Financial System
G.
FYI: Financial Crises
1. What are the key elements of a financial crisis?
a. A large decline in asset prices.
b. Insolvencies at some financial institutions.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. A stock is a claim to partial ownership in a firm. A bond is a certificate of indebtedness.
They are different in numerous ways: (1) a bond pays interest (a fixed payment determined
2. Private saving is the amount of income that households have left after paying their taxes and
paying for their consumption. Public saving is the amount of tax revenue that the
3. If more Americans adopted a “live for today” approach to life, they would spend more and
Chapter 13/Saving, Investment, and the Financial System ❖ 231
Questions for Review
1. The financial system's role is to help match one person's saving with another person's
investment. Two markets that are part of the financial system are the bond market, through
Quick Check Multiple Choice
1. d
Problems and Applications
1. a. The bond of an eastern European government would pay a higher interest rate than the
bond of the U.S. government because there would be a greater risk of default.
232 ❖ Chapter 13/Saving, Investment, and the Financial System
2. Companies encourage their employees to hold stock in the company because it gives the
employees the incentive to care about the firm’s profits, not just their own salaries. Then, if
3. To a macroeconomist, saving occurs when a person’s income exceeds his consumption, while
investment occurs when a person or firm purchases new capital, such as a house or business
equipment.
Chapter 13/Saving, Investment, and the Financial System ❖ 233
6. a. If interest rates increase, the costs of borrowing money to build the factory become
d. The loanable funds market would be in equilibrium at an interest rate of 8%. Harry
234 ❖ Chapter 13/Saving, Investment, and the Financial System
8. a. Figure 1 illustrates the effect of the $20 billion increase in government borrowing.
b. Because the interest rate has increased, investment and national saving decline and
c. The more elastic is the supply of loanable funds, the flatter the supply curve would be, so
Chapter 13/Saving, Investment, and the Financial System ❖ 235
e. If households believe that greater government borrowing today implies higher taxes to
9. a. Investment can be increased by reducing taxes on private saving or by reducing the
b. To know which of these policies would be a more effective way to raise investment, you
would need to know: (1) what the elasticity of private saving is with respect to the after-
