Lecture 3

Saving, Investment &

the Financial System
Prof. Dr. Qais Aslam
UCP, Lahore
Syllabus to be taught

• Introduction to Financial Institutions

• Market for loanable Funds
• Analysis of Basic tools of Finance
 Financial System
• Financial System consists of the institutions that help to match one
person’s saving with another person’s investment
• Financial system moves the economy’s scarce resources from savers
(people who spend less and save more) to borrowers (people who
spend more and earn less)
• The Financial system is made up of various financial institutions that
help coordinate the actions of savers and borrowers
• Most important of these institutions can be grouped into two
categories
1. Financial Markets, and
2. Financial Intermediaries
• Savers save for various reasons: to put a child through
college (university); to retire comfortable; or to start
a business in order to make a living etc.
• Savers supply their money to the financial system
with the expectation that they will get it back with
interest at a later date
• Borrowers demand money from the financial system
with the knowledge that they will require to pay it
back with interest at a later date
 I. Financial Markets
• Financial Markets are institutions through which a person, who want to save
can directly supply funds to a person who wants to borrow.
• Financial Markets include (1) Bond Market & (2) Stock Market
1. Bond Market:
• A Bond is a certificate of indebtedness that specifies the obligations of the
borrower to the holder of the bond
• Simply a bond is an IOU ( I Owe You some amount of Money to be paid back
at a future date with a certain amount of interest), identifying the time the
loan has to be paid back (repaid) called the date of maturity
• The rate of interest that will be paid periodically until the loan is matured
• The borrowed amount called the principal.
• The buyer of the bond can hold the bond until maturity or he can sell the
bond at an earlier date to some one else
 Characters of a Bond
i. Bond’s Term – is the length of time until the bond matures. Some
bonds have short term others have long term
• Perpetuity Bond – is a bond that never matures and pays interest
forever and the principle is never repaid
• The interest rate of a bond depends upon its term
• Long-term bonds are riskier than short-term bonds, because
holders of long-term bonds have to wait longer for repayment of
principal and if the holder has a need for money in the time, he has
no choice but to sell the bond to someone else , usually at a
reduced price
• To compensate for the risk, long-term bonds have higher interest
rates than the short run bonds
ii. Credit Risk of the bond – The probability that the borrower will
fail to pay some of the interest or principal
• Such a failure is called Default
• Borrowers can default on their bonds by calling in Bankruptcy
• When the bond buyers perceive that the probability of default is
high, they demand higher interest rates as a compensation for this
risk
• Financially shaky corporations raise money by issuing junk bonds,
which pay higher interest rates
• Buyers of bonds can judge credit risk by checking through credit
agencies which evaluate the credit risk of different bonds (AAA are
the safest, while D are already at default)
iii. Tax Treatment – or the way the tax laws treat the interest
earning on the bonds
• Interest on most bonds is taxable income
• When state or local governments issue bonds called Municipal
bonds, the owner of the bond is not required to pay federal
income tax from the earnings of some of these bonds, which than
pay relatively less interest rates than those that are taxable
 2. Stock Market
Another way of a firm to raise funds is to sell stocks of the company
• Stocks represent ownership in the firm, and is, therefore a claim on the profit
that a firm makes
• The Sale of stocks to raise money is called Equity Financing, whereas
• The Sale of bonds is called debt financing
• The owner of shares (stock holder) of a company is a part owner of the firm
and therefore takes a percentage share of the profit of the firm, whereas
• The owner of a bond (bond holder) only gets interest on their bonds
• If a firm gets into financial difficulty, the bond holders are paid first what they
are due and then only the stock holder gets anything if at all
• Compared to bonds, stock holders receive both higher risks as well as higher
returns
• After a corporation issues stock by selling shares to the public, these
shares are traded among stockholders on organized stock exchanges
(Stock Markets)
• In these transactions the corporations receive no money when its
stock exchange hands
• Price at which share trade on stock exchanges are determined by
the supply of and demand for the stock of these companies
• Because stock represents ownership in a corporation, the demand
for a stock (and thus its Price) reflects the people’s perception of the
corporation’s future profitability
• When people are optimistic about a corporation’s future the price
of its stock goes up and vice versa
 II Financial Intermediaries
1. Banks

• Unlike large corporations (which can finance their businesses through bonds
and shares ), small businesses would find it difficult to raise funds in the
bond and stock markets
• Small businesses therefore, most likely finances their business expansion
with a loan from a bank
• Banks are financial intermediaries with which people are most familiar
• Primary job of Banks is to take in deposits from people who want to save and
use these deposits to make loans to people who want to borrow
• Banks pay depositors interest on their deposits and charge borrowers slightly
higher interest on their loans
• The difference between these rates of interest covers the banks costs and
returns some profits to the owners of the banks
• Besides being financial intermediary, banks play another important role in
the economy
• Bank facilitate purchases of goods and services by allowing people to write
checks against their deposits and to access those deposits through debit
cards or credit cards
• In other words Banks help create special assets that people can use as
Medium of Exchange (First Function of Money)
• A Banks role in providing a medium of exchange distinguishes it from other
financial institutions
• Stocks and bonds, like bank deposits, are a possible Store Of Value (Second
Function of Money) for the wealth that people have accumulated in the past
savings or Unit of Account (Third Function of Money)
• But access to this wealth is not easy, cheap, and immediate as just writing a
check or swiping a debit card
 2. Mutual Funds
• Mutual Funds is an institution that sells shares to the public and uses the proceeds to buy a
selection (portfolio) of various types of stocks and bonds
• The shareholders of the mutual funds accepts all the risk and return associated with the
portfolio
• If the value of the portfolio rises, the shareholders benefit, and if the value of the portfolio
falls, the shareholders suffer a loss
• The primary advantage of the mutual funds is that they allow people with small amount of
money to diversify their holdings (or diversify the risk)
• Buyers of stocks and bonds are well advised to heed the adage: don’t put all your eggs in one
basket, because the value of any single stock or bond is tied to the fortunes of one company,
holding a single kind of stock or bond
• By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because
they have only a small stake in each company
• A second advantage claimed by Mutual Funds companies is that they give ordinary people
access to the skills of professional money managers who pay close attention to the
development and prospects of the companies in which they buy stock if these companies
seem to be profitable in the future (Financial Economists are often Skeptical of this argument)
 Saving & Investment in the National Income Accounts
• Events that occur within the financial system are central to understanding
developments in the overall economy
• The Financial system has a role of coordinating the economy’s saving and
investment decisions and are long-run determinants of GDP
• GDP Accounting rules tell us of how various identities (Macroeconomic
Variables) or numbers are defined and added up
• National Income Accounts include many related statistics as components
(identities) of GDP
Identities are equation that must be true because of the way the variables
In the equation are defined
• Identities are useful for they clarify how different variables are related to one
other
 Some Important Identities
• GDP is both Total Income (that have been earned by employment of Factors of
Production) as well as Total Expenditure on goods & services (that have been Produced)
in an economy
• GDP = (Y) is divided into four components of expenditure = Consumption (C ) plus
Investment (I) plus Government Expenditure (G) plus Net Exports (Xn), therefore
Y = C + I + G + Xn
• The equation is an identity, because every dollar (or Rs.) that shows up on the left side
also shows up on the right side
• A Closed Economy is one that does not interact with other economies (through
International Trade or Xn)
• An Open Economy is that interacts with other economies (through International Trade
or Xn)
• In a Closed economy (where Xn = zero) the equation would be
Y=C+I+G
 Y = C + I + G……(1)
GDP is the sum of Total Expenditure on
Consumption, Investment demand and Government spending

• Each output sold in a closed economy is consumed, invested or bought by the government
• Let us see what the identity tells us about the financial market
Y – C – G = I ……(2)
• (Y-C-G) is the total income in the economy that remains after paying for consumption and
government purchases. The amount is called national Savings, or just saving (s). Substituting s for
(Y-C-G) we get
S = I ….. (3)
Or Saving equals Investment where (S = Y – C – G)
• If T is Government Taxes, which governments collect from households as compulsory savings
and than spend it on Social Securities, welfare & Transfer Payments as G, than
S = (Y – T – C) + (T – G) …..(4)
• The two T’s in equation (4) cancel each other out, but each reveal a different way of thinking
about national savings. In particular private savings (Y - T -C) and Public Saving (T –G)
• Private savings (S = Y-T-C) is the amount of income (Y) that households
have left after paying their taxes (T) and paying for consumption (C)
• Public Saving (S = T-G) is the amount of tax (T) revenue that the
government has left after paying for government expenses (G) on goods
and services that it buys.
• If T exceeds G, the government runs a budget surplus because it receives
more money than it spends and public saving is positive
• If G exceeds T, the government runs a budget deficit because it spends
more money than it receives and public saving is negative
• The financial Market (Bonds market, stock market and financial
intermediaries) stand between saving (s) and Investment (I), because they
take in the nation’s saving and direct it to the nation’s Investments, or
• S = Financial Market = I
 Meaning of Saving & Investment
• In Macroeconomics Investment (I) refers to the purchase of new
capital, such as equipment or building or Investment Demand
• When some one borrows from the bank for personal consumption to
buy a house, he adds up to the nation’s investment
• When a Corporation sells some stock and uses the proceeds to build a
factory, the corporation adds up to the nation’s investment
• Although S= I is true for the entire economy, this is not necessarily true
for every individual, household or firm.
• Only financial markets make it possible or diverting one person’s saving
into another person’s investment
• The Model gives us a tool to analyze various government policies that
influence saving & investment
 Market for Loanable Funds
• Assuming that the economy has only one Financial Market called Market for Loanable
funds and all savers and investors go to this market for their deposits & loans.
• (Although in real life this assumption of single market is not rational)
• Thus the term Loanable funds refers to all the income that savers want to save after
their consumption, and the amount the investors want to borrow for new investments
• The Financial Market for loanable funds is also governed by the laws of Demand and
Supply
• The Supply of loanable funds comes from savers and demand for loanable funds
comes from investors
In other words,
• Saving is the source of Supply of loanable funds
• Borrowing by households & Businesses is the source of Demand of loanable funds
 Fig. 1. Supply & Demand of Loanable Funds (Market
for Loanable Funds)
Real
Interest
Rate
Supply = savers
(r)
in %

R = determined in the financial market

Demand =
borrowers

q Loanable Funds in Billion US$

 Explanation of Fig. 1.
Supply & Demand of Loanable Funds (Market for
Loanable Funds)
• Interest Rates (r) in the economy
adjusts to balance the supply & demand for loanable funds.
• Saving, both private and public, S = (Y – T – C) + (T – G),
supplies loanable funds.
• Borrowing by households and businesses for investment is
the Demand for loanable funds
• The Equilibrium determines the Interest Rate (Price of
loanable funds) in the Financial Market
• Interest rates (r ) should be high enough to induce saving and low enough to
induce investments
1. If the interest rate would be lower than the equilibrium level, than the quantity
of loanable funds supplied would be less than the quantity of loanable funds
demanded
• The resulting shortages of fund would rise the interest rates and induce savings to
rise and at the same time discourage borrowings for investments thereby
decreasing the quantity of loanable funds demanded, thereby restoring the
equilibrium interest rates
2. If the interest rate would be higher than the equilibrium level, than the quantity
of loanable funds supplied would be greater than the quantity of loanable funds
demanded
• The resulting surpluses of fund would lower the interest rates and induce savings
to fall and at the same time encourage borrowings for investments thereby
increasing the quantity of loanable funds demanded, thereby again restoring the
equilibrium interest rates
 Nominal Vs Real Interest Rates
• Nominal Interest Rates is the monetary returns to savings and the
monetary cost of borrowing. It is the interest rate usually reported
• Real Interest rate (r –P) is the nominal interest rate corrected for
inflation, or nominal interest rate minus inflation rates (price levels) or
(r –P)
• Because inflation erodes the value of money over time, the real
interest rates more accurately reflect the real return to savings and
the real cost of borrowing
• Therefore the supply and demand of loanable funds depend upon real
interest rates (rather than the nominal interest rates) and the
equilibrium in Fig 1 is the determination of real interest rates in the
economy
 Fig. 2. Policy 1 Saving Incentive
A change in tax laws to encourage savings would shift the saving curve
from S1 to S2. As a result, the equilibrium interest rates would fall from r1
to r2 and the lower interest rates would stimulate investment from q1 to
Real
Interest
q2 Supply
Rate S1
Tax incentives for savers
(r) increase the supply of
in % loanable funds to S2

Supply
r1 S2

r2

Demand

q1 q2 Loanable Funds in Billion US$

 Fig. 3. Policy 3 Investment Incentive
A change in tax laws to encourage Investments would shift
the demand curve from d1 to d2. As a result, the equilibrium
interest rates would rise from r1 to r2 and the higher interest
rates would stimulate savingst from q1 to q2
Real
Interest Supply
Rate
(r)
in % r2
Tax incentives for
r1 demand of
loanable funds
Demand
d2

Demand
d1

q1 q2 Loanable Funds in Billion US$

Fig. 4. Policy 3 Government Budget Deficit & surpluses.
When Government spends more than it receives as tax revenue, the
resulting budget deficit lowers national saving shifts the supply curve to
the left. The supply of loanable funds decrease from q2 to q1, & the
equilibrium interest rates rise from r1 to r2. Opposite is the case of
Government
Real
Surplus Supply
S2 A budget deficit
Interest decreases the supply of
Rate loanable funds to S2
(r)
in %
Supply
r2 S1

r1

Demand

q1 q2 Loanable Funds in Billion US$