Lecture 3b: Saving, Investment, and the Financial System

N. Gregory Mankiw

Principles of
Macroeconomics Sixth Edition

13
Saving, Investment,
and the Financial System Premium PowerPoint
Slides by
Ron Cronovich
2012 UPDATE
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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?
The Financial System

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and-loan-definition
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.
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
What do banks do?

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nancial-intermediaries
Introduction to stock markets

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arkets
 % of labor force

3
4
5
6
7
8
9
10
11
10-2007
12-2007
02-2008
04-2008
06-2008
08-2008
10-2008
12-2008
02-2009
04-2009
06-2009
08-2009
10-2009
12-2009
02-2010
04-2010
06-2010
08-2010
The Financial Crisis of 2008–2009

10-2010
12-2010
around the world. A few unemployment rates:

02-2011
04-2011
06-2011
08-2011
• A financial crisis led to a deep recession in the U.S. and

U.K.
USA

10-2011
France

Canada
Sweden

12-2011
02-2012
What Caused the 2008 Global Financial Crisis?

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nancial-intermediaries
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.
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.
Sources of saving in the economy
Different Kinds of Saving
Private saving Public saving
= The portion of households’ = Tax revenue less government
income that is not used for spending
consumption or paying taxes
=Y–T–C =T–G
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
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

Budget Deficits and Surpluses
Budget surplus
= an excess of tax revenue over govt spending
= T–G
= public saving
Budget deficit
= a shortfall of tax revenue from govt spending
= G–T
= – (public saving)
 ACTIVE LEARNING 1
A. Calculations

• Suppose GDP equals $10 trillion,

consumption equals $6.5 trillion,
the government spends $2 trillion
and has a budget deficit of $300 billion.
• Find public saving, taxes, private saving, national saving, and
investment.

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 ACTIVE LEARNING 1
Answers, part A
Given:
Y = 10.0, 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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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
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!
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
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.
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.
The Slope of the Supply Curve
An increase in
Interest
Rate Supply the interest rate
makes saving
more attractive,
6%
which increases
the quantity of
loanable funds
3% supplied.

60 80 Loanable Funds
($billions)
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.
The Slope of the Demand Curve
A fall in the interest
Interest
rate reduces the cost
Rate
of borrowing, which
7% increases the quantity
of loanable funds
demanded.
4%

Demand

50 80 Loanable Funds
($billions)
Equilibrium The interest rate
Interest adjusts to equate
Rate Supply supply and demand.

The eq’m quantity

5% of L.F. equals
eq’m investment
and eq’m saving.
Demand

60 Loanable Funds
($billions)
 Policy 1: Saving Incentives
Tax incentives for
Interest saving increase
Rate S1 S2 the supply of L.F.

…which reduces the

5%
eq’m interest rate
4%
and increases the
eq’m quantity of L.F.
D1

60 70 Loanable Funds
($billions)
 Policy 2: Investment Incentives
An investment tax
Interest credit increases the
Rate S1 demand for L.F.
6%
…which raises the
5% eq’m interest rate
and increases the
D2 eq’m quantity of L.F.
D1

60 70 Loanable Funds
($billions)
The Loanable Funds Market

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 ACTIVE LEARNING 2
Budget deficits
• 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 2
Answers
A budget deficit reduces
national saving and the
Interest S2 supply of L.F.
Rate S1

…which increases the

6% eq’m interest rate
5% and decreases the
eq’m quantity of L.F.
and investment.
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.
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.
 U.S. Government Debt
as a Percentage of GDP, 1790–2012
120%

WW2
100%

Financial
80% Crisis
Revolutionary
60% 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.
 SUMMARY

• 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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 SUMMARY

• 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.

© 2013 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.