To understand savings and investment, the functions of financials systems in the investments. how money is supply to the markets of financials investments and how money is used by the investors in the same market.

1. Premium PowerPoint Slides by:
V. Andreea CHIRITESCU
Eastern Illinois University
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
Saving, Investment, and
the Financial System
CHAPTER
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2. 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 government policies affect saving,
investment, and the interest rate?
2
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3. Financial Institutions
• Financial system
–Group of institutions in the economy that
help match the saving of one person with
the investment of another
• Financial institutions
–Institutions through which savers can
directly provide funds to borrowers
–Financial markets
–Financial intermediaries
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4. Financial Markets
• Financial markets
–Savers can directly provide funds to
borrowers
–The bond market:
• A bond is a certificate of indebtedness
–The stock market:
• A stock is a claim to partial ownership in a
firm
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5. Financial Intermediaries
• Financial intermediaries
–Institutions through which savers can
indirectly provide funds to borrowers
–Banks
–Mutual funds: institutions that sell shares
to the public and use the proceeds to buy
portfolios of stocks and bonds
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6. The Financial Crisis of 2008–2009
A financial crisis led to a deep recession in the U.S. and
around the world. A few unemployment rates:
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USA
France
U.K.
Canada
Sweden
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7. 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
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8. 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.
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9. Accounting Identities
• Gross domestic product (GDP, Y)
–Total income = Total expenditure
Y = C + I + G + NX
• Y = gross domestic product, GDP
• C = consumption
• I = investment
• G = government purchases
• NX = net exports
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10. Accounting Identities
• Assume closed economy: NX = 0
• Y = C + I + G, so I = Y – C - G
• National saving (saving), S
• Total income in the economy that remains
after paying for consumption and
government purchases
• By definition: S = Y – C – G
• It follows: Saving (S) = Investment (I)
for a closed economy
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11. Accounting Identities
–For T = taxes minus transfer payments
S = Y – C – G can be rewritten as:
S = (Y – T – C) + (T – G)
• Private saving, Y – T – C
–Income that households have left after
paying for taxes and consumption
• Public saving, T – G
–Tax revenue that the government has left
after paying for its spending
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12. Accounting Identities
• Budget surplus: T – G > 0
–Excess of tax revenue over government
spending = public saving (T-G)
• Budget deficit: T – G < 0
–Shortfall of tax revenue from government
spending = – (public saving) = G – T
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13. 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, net taxes, private saving,
national saving, and investment.
13
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14. Active Learning 1 A. Answers
Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
(all in trillions)
• Public saving = T – G = – 0.3
• Net taxes: T = G – 0.3 = 1.7
• Private saving = Y–T–C = 10 – 1.7 – 6.5 = 1.8
• National saving S=Y–C–G = 10 – 6.5 – 2 = 1.5
• Investment = national saving = 1.5
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15. Active Learning 1 B. How a tax cut affects saving
Use the numbers from the preceding exercise,
but suppose now that the government cuts
taxes by $200 billion.
In each of the following two scenarios, determine
what happens to public saving, private saving,
national saving, and investment.
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend
the other 3/4.
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16. Active Learning 1 B. Answers
In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged, so investment
is unchanged.
2. If consumers save $50 billion and spend
$150 billion, then national saving and
investment each fall by $150 billion.
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17. Active Learning 1 C. Discussion questions
The two scenarios from this exercise were:
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend
the other 3/4.
• Which of these two scenarios do you think is
more realistic?
• Why is this question important?
17
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18. The Meaning of Saving and Investment
• Private saving
–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
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19. 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 $300,000 to have a new
house built.
Investment is NOT the purchase of stocks and bonds!
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20. The Market for Loanable Funds
• Loanable funds market
–A supply–demand model of the financial
system
–Helps us understand:
• How the financial system coordinates
saving & investment.
• How government policies and other factors
affect saving, investment, the interest rate.
20
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21. The Market for Loanable Funds
• Assume: only one financial market
–All savers deposit their saving in this
market.
–All borrowers take out loans from this
market.
–There is one interest rate, which is both
the return to saving and the cost of
borrowing.
21
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22. The Market for Loanable Funds
• The supply of loanable funds comes from
saving:
–Households with extra income can loan it
out and earn interest.
–Public saving
• If positive, adds to national saving and the
supply of loanable funds.
• If negative, it reduces national saving and the
supply of loanable funds.
22
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23. The Slope of the Supply Curve
An increase in the
interest rate makes
saving more
attractive, which
increases the
quantity of loanable
funds supplied.
Interest
Rate
Loanable Funds
($billions)
Supply
60
3%
80
6%
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24. 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.
24
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25. The Slope of the Demand Curve
A fall in the interest
rate reduces the cost
of borrowing, which
increases the quantity
of loanable funds
demanded.
Interest
Rate
Loanable Funds
($billions)
Demand
50
7%
4%
80
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26. Equilibrium
The interest rate adjusts
to equate supply and
demand.
The equilibrium quantity
of loanable funds equals
equilibrium investment
and equilibrium saving.
Interest
Rate
Loanable Funds
($billions)
Demand
Supply
5%
60
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27. Policy 1: Saving Incentives
Tax incentives for
saving increase the
supply of loanable
funds
…which reduces the
equilibrium interest
rate
and increases the
equilibrium quantity of
loanable funds
Interest
Rate
Loanable Funds
($billions)
D1
S1
5%
60
S2
4%
70
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28. Policy 2: Investment Incentives
An investment tax
credit increases the
demand for loanable
funds
…which raises the
equilibrium interest
rate
and increases the
equilibrium quantity
of loanable funds
Interest
Rate
Loanable Funds
($billions)
D1
S1
5%
60
6%
70
D2
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29. 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?
29
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30. Active Learning 2 Answers
A budget deficit
reduces national
saving and the
supply of loanable
funds
…which increases
the equilibrium
interest rate
and decreases the
equilibrium quantity
of loanable funds
and investment.
30
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Interest
Rate
Loanable Funds
($billions)
D1
S1
5%
60
S2
6%
50

31. Budget Deficits, Crowding Out,
and Long-Run Growth
• Our analysis:
– Increase in budget deficit causes fall in investment
– The government borrows to finance its deficit,
leaving less funds available for investment:
crowding out
• Investment is important for long-run economic
growth
• Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
31
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32. ASK THE EXPERTS
32
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Fiscal Policy and Saving
“Sustained tax and spending policies that
boost consumption in ways that reduce the
saving rate are likely to lower long-run living
standards.”

33. The U.S. Government Debt
• The government finances deficits by
borrowing (selling government bonds).
– Persistent deficits lead to a rising government
debt.
• The ratio of government debt to GDP
– 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.
33
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34. U.S. Government Debt as a Percentage of GDP
1790–2012
34
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35. Conclusion
Markets are usually a good way to organize
economic activity
• Financial markets: governed by the forces of
supply and demand
– Help allocate the economy’s scarce resources
to their most efficient uses.
– Link the present to the future
• Savers: convert current income into future
purchasing power
• Borrowers: acquire capital to produce goods
and services in the future
35
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36. 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.
36
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37. 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.
37
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