Chapter 26: Saving, Investment and the Financial System

Saving, Investment, and the Financial System

Financial institutions connect people who save money with households, businesses, and governments that want to borrow. The market for loanable funds shows how saving and investment are coordinated, and how public policies can affect interest rates and long-run economic growth.

Financial Markets and Financial Intermediaries

Financial markets let savers and borrowers interact directly.

• Bond market: A bond is a certificate of debt, or an IOU. The seller is the borrower, and the buyer is the lender.
  • A bond specifies its maturity date and interest rate.
  • Longer-term bonds generally pay higher interest because lending for longer involves more risk.
  • Credit risk is the chance that a borrower will fail to repay some or all of the principal. Riskier bonds generally offer higher interest rates; high-risk bonds are often called junk bonds.
  • Municipal bonds may receive favorable tax treatment, allowing them to offer lower interest rates than otherwise comparable taxable bonds.
• Stock market: A share of stock represents partial ownership of a corporation and a claim on its profits.
  • Selling stock is equity finance; selling bonds is debt finance.
  • Stockholders are owners, while bondholders are creditors. In bankruptcy, creditors have a legal claim to assets; owners do not have the same claim.
  • Stock prices are determined by supply and demand. Because the number of shares outstanding usually changes infrequently, price movements mainly reflect changes in demand—especially investors’ expectations about future profitability.

Financial intermediaries stand between savers and borrowers.

• Banks accept deposits and lend the funds to borrowers, typically charging more on loans than they pay depositors.
• Banks also provide checkable deposits, such as checking accounts accessed by check or debit card, which can be used to make purchases.
• Other intermediaries include mutual funds, credit unions, and pension funds.

National Saving and Investment

The lecture begins with the national income identity:

Y = C + I + G + NX

For a simplified closed economy, net exports are set to zero:

Y = C + I + G

Rearranging gives:

Y − C − G = I

The left side is national saving, so in this model:

National saving = Investment

Here, investment means businesses’ purchases of equipment and buildings, as well as residential investment such as home construction. Buying stocks or bonds is a form of saving or financial investment, not investment in the national-income-accounting sense.

National saving can be divided into:

• Private saving: Y − T − C — income remaining after taxes and consumption.
• Public saving: T − G — government tax revenue minus government spending.
  • If T > G, the government has a budget surplus.
  • If T < G, it has a budget deficit.

The Market for Loanable Funds

The model explains how saving and investment are brought into equality:

• The supply of loanable funds comes from savers who lend or otherwise make purchasing power available for future use.
• The demand for loanable funds comes from households and businesses that borrow to finance investment.
• The real interest rate is the price of borrowing: it is a cost to borrowers and a reward to lenders.
• The supply curve slopes upward: higher interest rates encourage more saving and lending.
• The demand curve slopes downward: higher interest rates discourage borrowing.

The intersection of supply and demand determines the equilibrium interest rate and the equilibrium quantity of funds—the amount saved and invested.

How the Market Moves Toward Equilibrium

• If the interest rate is below equilibrium, there is a shortage of loanable funds: borrowers want more funds than savers provide. Competition for loans puts upward pressure on interest rates. As rates rise, saving increases and borrowing decreases.
• If the interest rate is above equilibrium, there is a surplus of loanable funds: savers want to lend more than borrowers want to borrow. Lenders have an incentive to offer lower rates, putting downward pressure on interest rates.
• These incentives push the market toward the equilibrium rate.

How Policies Affect Saving, Investment, and Growth

The lecture applies the model to policies that shift the supply or demand for loanable funds.

• Higher taxes on returns to saving, illustrated by an increase in the capital gains tax, reduce the reward to saving.

  • The supply of loanable funds shifts left.
  • The equilibrium interest rate rises, while the quantity of saving and investment falls.
  • Since greater saving and investment are associated with higher future growth, policies that discourage them may reduce long-run growth, all else equal.

• An investment tax credit encourages firms to invest by lowering the effective cost of investment.

  • The demand for loanable funds shifts right.
  • The equilibrium interest rate and the quantity of saving and investment rise.
  • Removing or reducing the credit would have the opposite effect.

• A government budget deficit means government spending exceeds tax revenue, making public saving negative and reducing national saving.

  • The supply of loanable funds shifts left.
  • The equilibrium interest rate rises, and the quantity of saving and investment falls.
  • The resulting decline in private investment is called crowding out. The lecture notes that this can weaken long-run growth, all else equal.
  • A budget surplus has the opposite effect: it increases national saving, lowers the interest rate, and raises the amount of saving and investment.

Speakers and Sources Featured

• Speaker: One unnamed male economics lecturer or instructor. The subtitles do not provide his name; the video is from the DrAzevedoEcon channel.