N. Gregory MankiwMacroeconomicsBrief Principles ofSixt.docx

N. Gregory Mankiw
Macroeconomics
Brief Principles of
Sixth Edition
8
Saving, Investment,
and the Financial System
© 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.
Premium PowerPoint
Slides by
Ron Cronovich
2012 UPDATE
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This chapter is an excellent follow-up to the previous one
(“Production and Growth”). In that chapter, we learn that
investment—the accumulation of capital—is important because
it leads to a higher standard of living in the long run. But what
determines how much investment a country undertakes? That is
the present chapter’s central question.

After some introductory information about the various types of
financial institutions, the chapter focuses on saving and
investment. Students will learn the difference between private
and public saving, and the definitions of government budget
surpluses and deficits. The brief review of the difference
between saving and investment is very useful, as intro-level
students often use the term “investment” when they mean to say
“saving.”
The most analytical part of the chapter is the coverage of the
closed-economy loanable funds model. This model uses the
tools of supply and demand (introduced in Chapter 4) and
should be very familiar if your students have already taken
introductory microeconomics.
The loanable funds model shows how the interest rate adjusts to
equate saving and investment in a closed economy. Students
will learn how government budget deficits can crowd out
investment, which is probably one of the biggest ideas in
macroeconomics.
0
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?
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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.
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2
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
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3
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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Motivated by the recent economic crisis and recession, the sixth
edition adds an FYI box discussing the elements of financial
crises. The data here will help motivate the topic.
Source of all unemployment figures:
http://research.stlouisfed.org/fred2
4
USA 39083 39114 39142 39173 39203 39234
39264 39295 39326 39356 39387 39417

39448 39479 39508 39539 39569 39600
39630 39661 39692 39722 39753 39783
39814 39845 39873 39904 39934 39965
39995 40026 40057 40087 40118 40148
40179 40210 40238 40269 40299 40330
40360 40391 40422 40452 40483 40513
40544 40575 40603 40634 40664 40695
40725 40756 40787 40817 40848 40878
40909 40940 4.5999999999999996 4.5
4.4000000000000004 4.5 4.4000000000000004
4.5999999999999996 4.7 4.5999999999999996
4.7 4.7 4.7 5 5 4.9000000000000004
5.0999999999999996 5 5.4 5.6 5.8 6.1 6.1
6.5 6.8 7.3 7.8 8.3000000000000007
8.6999999999999993 8.9 9.4 9.5 9.5 9.6
9.8000000000000007 10 9.9 9.9
9.6999999999999993 9.8000000000000007
9.8000000000000007 9.9 9.6 9.4 9.5 9.6 9.5
9.5 9.8000000000000007 9.4 9.1 9 8.9 9 9
9.1 9.1 9.1 9 8.9 8.6999999999999993 8.5
8.3000000000000007 8.3000000000000007 France
39083 39114 39142 39173 39203 39234
39264 39295 39326 39356 39387 39417
39448 39479 39508 39539 39569 39600
39630 39661 39692 39722 39753 39783
39814 39845 39873 39904 39934 39965
39995 40026 40057 40087 40118 40148
40179 40210 40238 40269 40299 40330
40360 40391 40422 40452 40483 40513
40544 40575 40603 40634 40664 40695
40725 40756 40787 40817 40848 40878
40909 40940 8.8000000000000007
8.8000000000000007 8.6999999999999993 8.5
8.5 8.4 8.4 8.3000000000000007
8.1999999999999993 8.1 7.9 7.7 7.6 7.5 7.5
7.6 7.6 7.7 7.8 7.8 7.9 8 8.1999999999999993

8.4 8.6 8.9 9.1999999999999993 9.4 9.6 9.5
9.5 9.6 9.6999999999999993 10 10 10 10
9.9 9.8000000000000007 9.6999999999999993
9.6999999999999993 9.6999999999999993
9.6999999999999993 9.8000000000000007
9.8000000000000007 9.6999999999999993
9.6999999999999993 9.6999999999999993 9.6
9.6 9.6 9.6 9.5 9.6 9.6 9.6 9.6999999999999993
9.6999999999999993 9.8000000000000007 9.9 10
10.1 U.K. 39083 39114 39142 39173 39203
39234 39264 39295 39326 39356 39387
39417 39448 39479 39508 39539 39569
39600 39630 39661 39692 39722 39753
39783 39814 39845 39873 39904 39934
39965 39995 40026 40057 40087 40118
40148 40179 40210 40238 40269 40299
40330 40360 40391 40422 40452 40483
40513 40544 40575 40603 40634 40664
40695 40725 40756 40787 40817 40848
40878 40909 40940 5.5 5.5 5.5 5.4 5.3
5.3 5.3 5.3 5.2 5.0999999999999996 5
5.0999999999999996 5.0999999999999996
5.0999999999999996 5.2 5.2 5.3 5.5 5.7 5.8
5.9 6.1 6.3 6.5 6.8 7.1 7.3 7.6 7.7 7.9 7.8
7.8 7.8 7.7 7.7 7.7 7.9 8 7.9 7.8 7.8 7.8
7.7 7.6 7.7 7.7 7.7 7.8 7.8 7.7 7.7 7.8 7.9 8
8.1 8.3000000000000007 8.3000000000000007
8.3000000000000007 8.3000000000000007
8.3000000000000007 8.1999999999999993 8.1
Canada 39083 39114 39142 39173 39203
39234 39264 39295 39326 39356 39387
39417 39448 39479 39508 39539 39569
39600 39630 39661 39692 39722 39753
39783 39814 39845 39873 39904 39934
39965 39995 40026 40057 40087 40118
40148 40179 40210 40238 40269 40299

40330 40360 40391 40422 40452 40483
40513 40544 40575 40603 40634 40664
40695 40725 40756 40787 40817 40848
40878 40909 40940 6.3 6.2 6.1 6.1 6
6.1 6.1 6 5.9 5.9 6 6 5.9 5.9 6.1 6.1
6.1 6 6.1 6.1 6.2 6.1 6.4 6.8 7.3 8 8.1
8.1999999999999993 8.5 8.6 8.6
8.6999999999999993 8.3000000000000007
8.3000000000000007 8.4 8.5 8.1999999999999993
8.1999999999999993 8.1999999999999993 8.1
8.1 7.9 8 8.1 8 7.8 7.6 7.6 7.7 7.7 7.6
7.6 7.4 7.4 7.3 7.3 7.2 7.4 7.5 7.5 7.6 7.4
Sweden 39083 39114 39142 39173 39203
39234 39264 39295 39326 39356 39387
39417 39448 39479 39508 39539 39569
39600 39630 39661 39692 39722 39753
39783 39814 39845 39873 39904 39934
39965 39995 40026 40057 40087 40118
40148 40179 40210 40238 40269 40299
40330 40360 40391 40422 40452 40483
40513 40544 40575 40603 40634 40664
40695 40725 40756 40787 40817 40848
40878 40909 40940 6.6 6.2 6.5 6.1 5.9
6.2 5.8 6 6.1 6.2 6 6 6 5.8 5.8 5.6
5.8 6.6 6.2 5.9 6.4 6.3 7 6.8 6.8 7.7 7.8
7.8 8.9 8.4 8.4 8.800 0000000000007
8.6999999999999993 8.6999999999999993
8.6999999999999993 8.9 8.8000000000000007
8.8000000000000007 8.5 9.1 8.6 8.1 8.5
8.1999999999999993 8.1999999999999993 8
7.8 7.8 7.8 7.6 7.7 7.4 7.7 7.5 7.4 7.4 7.3
7.5 7.4 7.5 7.6 7.5
% of labor force

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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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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Different Kinds of Saving
Private saving
= The portion of households’ income that is not used for
consumption or paying taxes
= Y – T – C
Public saving
= Tax revenue less government spending
= T – G
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In case anyone asks, “T” here (and in general) is net of transfer
payments.
After presenting this slide and the next, it might be useful to
point out the following:
In general, “saving” is just some measure of income minus some
measure of expenditure.
For private (household) saving, the measure of income is
“disposable income,” or gross income minus taxes (“take-home
pay”). The measure of expenditure is consumption.

For public (government) saving, the measure of income is T,
total taxes, which is the government’s source of “income.” The
measure of expenditure is simply G, government purchases.
In the case of national saving (covered on the next slide), the
measure of income is GDP, and the measure of expenditure is
C+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
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8
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
Solve for I:

I = Y – C – G
= (Y – T – C) + (T – G)
Saving = investment in a closed economy
national saving
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In defense of the closed economy assumption:
It’s true that most economies are open. However, the closed
economy case is easier to learn, and we can still learn a lot
about how the world works by studying the closed economy
case.
A later chapter will add international trade and capital flows to
this model.
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)

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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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This exercise asks your students to apply the concepts from the
preceding slides to the kind of problem they might see on an
upcoming exam.
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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All numbers are in trillions of dollars.
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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This exercise is designed to teach an important lesson and
prevent a common mistake among students.
When students are asked (on an exam, for example) to
determine the effects of a tax cut on national saving,
investment, and the interest rate, many students mistakenly state
that the tax change has no effects because taxes enter positively
in the expression for public saving, negatively in the expression
for private saving, and not at all in the expression for national
saving (Y – C – G).
This exercise gets students to see that the effects of a tax cut on
national saving and investment depend on the behavior of

consumers.
Immediately following this exercise is a discussion question
designed to help students realize that the tax cut will most
likely cause consumption to rise and national saving to fall.
Of course, if you intend to teach your students that Ricardian
Equivalence is an accurate description of the world, then you’d
want to argue that scenario 1 is the most realistic. The reason
for this, according to Ricardian Equivalence, is that consumers
are forward-looking and realize that a tax cut today must be
matched by a future tax increase that is equal in present value to
today’s tax cut. Please be aware, however, that Ricardian
Equivalence is not covered in this chapter, so it is not supported
with test bank or study guide questions.
ACTIVE LEARNING 1
Answers, part B
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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All numbers are in trillions of dollars.
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?
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If students have trouble understanding the first question, you
can rephrase it in terms they are likely to grasp:

Suppose a tax cut causes your annual take-home pay to rise
from $40,000 to $42,000. What would you do with that extra
$2000? Would you save ALL of it? Or would you spend at
least part of it?
In this light, most students would agree that the most realistic
scenario involves consumers spending at least part of the
proceeds of the tax cut.
The answer to the first question determines whether a tax cut
reduces investment. This is important because a fall in
investment would cause, in the long run, a fall in the standard
of living, according to what we learned in the Production and
Growth chapter.
The bigger point is this: while tax cuts seem appealing (nobody
likes paying taxes, after all), they are not without cost. Later in
the chapter, we will see HOW a tax cut causes investment to fall
in a closed economy. (Answer: by raising interest rates.)
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
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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!
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In principle, students should already know the meaning of
“investment,” which was introduced in the “Measuring National
Income” chapter. However, many students continue to think of
“investment” as the purchase of stocks, bonds, or other assets.
At this point in the chapter, a review of “saving” and
“investment” is especially worthwhile because the next topic is
the loanable funds model. In this model, saving is the supply of
funds and investment is the demand.

There’s a connection between the economics definition of
investment and the commonplace usage of the term: What
laypeople think of as financial investment (the purchase of
stocks and bonds, etc.) is what finances investment in physical
capital. For example, General Motors may sell $300 million
worth of bonds to raise the funds it needs to pay for its new
factory in Flint, Michigan. In this case, people buying the
bonds are doing “investment” in the layperson’s sense of the
term, and GM is using their funds to pay for the physical
investment.
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
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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.
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19
In defense of the assumption of just one financial market:
We are using this model to study the aggregate financial system.
It’s fine to assume there’s only one type of asset as long as we
don’t need to know how households divide their financial
wealth into various types of assets.
An analogy might help. Suppose you want to know how a fall
in consumer income affects the automobile market. You could
draw a supply–demand model for autos, in which the demand
curve would shift leftward, causing the price and quantity to
fall. Of course, this model ignores the fact that there are lots of
different types of vehicles, but that isn’t relevant to the issue at
hand.
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.

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The Slope of the Supply Curve
Interest
Rate
Loanable Funds ($billions)
Supply
An increase in the interest rate makes saving more attractive,
which increases the quantity of loanable funds supplied.
60
3%
80
6%
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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.
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The Slope of the Demand Curve
Interest
Rate
Demand

A fall in the interest rate reduces the cost of borrowing, which
increases the quantity of loanable funds demanded.
50
7%
4%
80
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Equilibrium
Interest
Rate
Demand
The interest rate adjusts to equate supply and demand.
Supply
The eq’m quantity of L.F. equals eq’m investment and eq’m

saving.
5%
60
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24
Due to space constraints, this slide uses “L.F.” to stand for
loanable funds, and “eq’m” to stand for equilibrium.
If the interest rate were lower than the equilibrium level,
demand for funds would exceed supply, causing the interest rate
to rise. The rise in the rate would make borrowing more costly,
and thus would reduce the demand for funds. The rise in the
interest rate would also encourage households to save more,
which would increase the supply of funds. This process would
occur until equilibrium was achieved.
If the interest rate were higher than equilibrium, there would be
a surplus of funds. The interest rate would fall to restore
equilibrium.
In the real world, the adjustment to equilibrium in financial
markets is extremely rapid.

Policy 1: Saving Incentives
Interest
Rate
D1
Tax incentives for saving increase the supply of L.F.
S1
5%
60
S2
…which reduces the eq’m interest rate
and increases the eq’m quantity of L.F.
4%
70
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There’s an implicit assumption in this analysis that overall tax
revenues remain unchanged in spite of the tax incentives.
Taken literally, we would have to assume that other taxes are
raised to exactly offset the loss in revenue from the saving
incentives. Without this implicit assumption, total tax revenues
would fall, causing saving to fall, and shifting the supply curve
leftward, which would mitigate the effects shown here.
You may or may not wish to point this out to your students. If
you are especially nitpicky, or your students are particularly
sharp, then it’s probably worth telling them. (Note, however,
that the assumption of constant total revenue remains implicit in
the textbook’s discussion of this policy.)
Policy 2: Investment Incentives
Interest
Rate
D1
An investment tax credit increases the demand for L.F.
S1
5%
60
…which raises the eq’m interest rate
and increases the eq’m quantity of L.F.
6%

70
D2
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As with Policy 1, you may wish to note that we are assuming
the tax credit does not significantly reduce the overall amount
of taxes. If total taxes fell, then the supply curve would shift
(in addition to the demand curve). However, our intention here
is to focus solely on the demand shift.
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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Now that you have shown students the analysis of Policies 1 and
2, this exercise asks them to do the analysis of Policy 3 (a
budget deficit).
In case you prefer to lecture on this material, I have provided a
“hidden” slide at the end of this file that contains the budget
deficit analysis as a lecture slide instead of an exercise. Move
that slide to this location and “unhide” it by unselecting the
“hide slide” command on the Slide Show menu.
ACTIVE LEARNING 2
Answers
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Interest

Rate
D1
A budget deficit reduces national saving and the supply of L.F.
S1
5%
60
S2
…which increases the eq’m interest rate
and decreases the eq’m quantity of L.F. and investment.
6%
50
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Some students ask why the budget deficit shifts the S curve
rather than the D curve; after all, governments finance their
deficits by borrowing. The reason is that we have defined
supply of L.F. as the flow of resources available to fund private

investment. The budget deficit reduces this supply of resources.
In the real world, we sometimes see increases in government
budget deficits that are not accompanied by dollar-for-dollar
decreases in investment, as the analysis on this slide would
predict. Keep in mind, however, that the analysis here is for the
closed economy model. In an open economy, firms can finance
investment by borrowing from abroad in the face of a decrease
in the domestic supply of loanable funds.
This, of course, does not mean that budget deficits are “okay” in
an open economy, because the extra indebtedness requires
service, such as interest or dividend payments, which reduces
the amount of income remaining for residents of the country.
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.
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29
If the last statement on this slide troubles you, here is my
defense:
While the budget deficit does not affect the steady state growth
rate of neoclassical growth theory, it affects the economy’s
growth rate temporarily (long enough to reduce the steady-state
level of income per capita). And in some endogenous growth
models, budget deficits can affect the steady state growth rate.
If you are still troubled, you can modify the statement so that it
is more consistent with neoclassical growth theory. (Perhaps
“Investment is important for long-run living standards.”)
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.
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30

U.S. Government Debt
as a Percentage of GDP, 1790–2012
Revolutionary War
Civil
War
WW1
WW2
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31
31
Note that the 2010 debt figure, at 63.6% of GDP, is higher than
at any time besides WW2, including all other wars.
From the beginning of this long time series until about 1980,
the data show a clear pattern: the debt-GDP ratio jumps up
during wartime, and comes back down during peacetime. (Also,
the Great Depression caused revenues to plummet, and led to a
rise in the debt ratio during the 1930s.)
There are two reasons why many economists believe it is
appropriate to allow the debt ratio to climb during wars. First,
it allows the government to keep tax rates smooth over time.
Wars are expensive, and financing them solely with tax

increases would be disruptive to the economy and would cause a
substantial reduction in economic efficiency. Second, debt
finance shifts part of the cost of the war to future generations.
This is appropriate, one could argue, because future generations
benefit when the government goes to war to defend the nation
against foreign aggressors.
The pattern visible throughout most of history breaks down
around 1980, when the debt ratio started climbing despite the
lack of a major war. This was due to the Reagan tax cuts, and
growth in federal entitlement outlays during the 1980s.
From 1992 to 2000, the longest expansion on record plus a
strong stock market in 1995–2000 led to a surge in revenues,
the first budget surpluses in many years, and a declining debt-
GDP ratio.
From 2001–2005, the ratio to start climbing again due to the
Bush tax cuts, the 2001 recession, and the wars (Afghanistan,
Iraq, and the War on Terror).
The ratio shoots up dramatically in 2008–2010 due to the
financial crisis and recession.
Sources:
prior to 1940, same as text
1940 to present, Table 7.1—FEDERAL DEBT AT THE END OF
YEAR, Budget of the United States Government: Historical
Tables Fiscal Year 2010,
http://www.gpoaccess.gov/usbudget/fy10/hist.html
debt-GNP ratio 1791 1792 1793 1794 1795 1796 1797 1798 1799
1800 1801 1802 1803 1804 1805 1806 1807 1808 1809 1810
1811 1812 1813 1814 1815 1816 1817 1818 1819 1820 1821
1822 1823 1824 1825 1826 1827 1828 1829 1830 1831 1832

1833 1834 1835 1836 1837 1838 1839 1840 1841 1842 1843
1844 1845 1846 1847 1848 1849 1850 1851 1852 1853 1854
1855 1856 1857 1858 1859 1860 1861 1862 1863 1864 1865
1866 1867 1868 1869 1870 1871 1872 1873 1874 1875 1876
1877 1878 1879 1880 1881 1882 1883 1884 1885 1886 1887
1888 1889 1890 1891 1892 1893 1894 1895 1896 1897 1898
1899 1900 1901 1902 1903 1904 1905 1906 1907 1908 1909
1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920
1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931
1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942
1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953
1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964
1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975
1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
2009 2010 2011 0.42 0.39900000000000002
0.35899999999999999 0.313 0.2680
0000000000002 0.24099999999999999
0.24299999999999999 0.23400000000000001 0.222
0.22 0.19400000000000001 0.20399999999999999
0.20200000000000001 0.19 0.159
0.14699999999999999 0.13600000000000001
0.13100000000000001 0.104
8.7999999999999995E-2 0.08 8.4000000000000005E-2
9.5000000000000001E-2 0.107 0.128
0.13800000000000001 0.122 0.105 0.111
0.122 0.13 0.11799999999999999
0.11799999999999999 0.111
9.2999999999999999E-2 9.0999999999999998E-2
8.2000000000000003E-2 7.0000000000000007E-2
5.8000000000000003E-2 4.8000000000000001E-2
3.2000000000000001E-2 1.4999999999999999E-2
5.0000000000000001E-3 2E-3 3.0000000000000001E-5 0
1E-3 4.0000000000000001E-3 4.0000000000000001E-3
3.0000000000000001E-3 6.0000000000000001E-3 1.6E-2

0.02 1.2999999999999999E-2 0.01
1.4999999999999999E-2 2.1000000000000001E-2
2.9000000000000001E-2 3.2000000000000001E-2
2.9000000000000001E-2 2.9000000000000001E-2
2.5999999999999999E-2 1.9E-2
1.2999999999999999E-2 1.0999999999999999E-2
8.9999999999999993E-3 0.01 1.6E-2
1.7999999999999999E-2 2.1999999999999999E-2
8.4000000000000005E-2 0.19400000000000001
0.27100000000000002 0.28699999999999998
0.34399999999999997 0.34499999999999997
0.34100000000000003 0.32800000000000001 0.318
0.31900000000000001 0.29799999999999999 0.255
0.24099999999999999 0.24199999999999999
0.24299999999999999 0.23499999999999999
0.23200000000000001 0.24299999999999999
0.23100000000000001 0.17799999999999999
0.16700000000000001 0.14299999999999999
0.13400000000000001 0.13200000000000001
0.13500000000000001 0.127 0.115 0.105
9.0999999999999998E-2 7.9000000000000001E-2
7.0999999999999994E-2 6.8000000000000005E-2
6.9000000000000006E-2 7.9000000000000001E-2
8.2000000000000003E-2 8.5999999999999993E-2
8.2000000000000003E-2 8.3000000000000004E-2
7.6999999999999999E-2 6.5000000000000002E-2
5.8999999999999997E-2 5.3999999999999999E-2 0.05
4.9000000000000002E-2 4.4999999999999998E-2
4.1000000000000002E-2 3.9E-2
4.1000000000000002E-2 3.6999999999999998E-2
3.4000000000000002E-2 3.4000000000000002E-2
3.2000000000000001E-2 3.1E-2 3.1E-2
2.9000000000000001E-2 4.1000000000000002E-2 0.123
0.248 0.314 0.27 0.316 0.30499999999999999
0.252 0.23699999999999999 0.219
0.19400000000000001 0.187 0.17499999999999999

0.158 0.17899999999999999 0.23499999999999999
0.35499999999999998 0.437 0.42
0.42299999999999999 0.41699999999999998
0.39800000000000002 0.44800000000000001 0.45
0.44800000000000001 0.45600000000000002
0.60299999999999998 0.78700000000000003
0.95399999999999996 1.0669999999999999 1.044
0.89600000000000002 0.79400000000000004
0.80500000000000005 0.73199999999999998 0.628
0.6 0.57999999999999996 0.58799999999999997
0.53700000000000003 0.501 0.48 0.49
0.46200000000000002 0.44800000000000001 0.443
0.42599999999999999 0.41099999 999999998
0.38700000000000001 0.36199999999999999
0.33400000000000002 0.33100000000000002 0.31
0.28399999999999997 0.28100000000000003
0.27600000000000002 0.26600000000000001 0.245
0.24399999999999999 0.26500000000000001
0.27300000000000002 0.27500000000000002
0.26600000000000001 0.254 0.25800000000000001
0.26 0.29699999999999999 0.33100000000000002
0.34 0.36399999999999999 0.39400000000000002
0.40699999999999997 0.41 0.40600000000000003
0.42 0.45300000000000001 0.48099999999999998
0.49399999999999999 0.49299999999999999
0.49199999999999999 0.48499999999999999
0.46100000000000002 0.43099999999999999
0.39400000000000002 0.34699999999999998
0.32500000000000001 0.33600000000000002
0.35599999999999998 0.36799999999999999
0.36899999999999999 0.36499999999999999
0.36199999999999999 0.40300000000000002
0.53500000000000003 0.622 0.72

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.
‹#›
classroom use.
‹#›
32
It might be worth elaborating for a moment on “financial
markets help allocate the economy’s scarce resources to their
most efficient uses.”
The scarce resources this statement refers to are the loanable
funds. They are scarce because there are more investment
projects needing funding than funds available. So how should
the scarce funds be allocated? I.e., which investment projects
should get the available funds? The investment projects with
the highest expected returns, of course. And the projects with
the highest expected returns would have the highest willingness
to pay for funds.
Hence, supply and demand for funds determines the equilibrium

interest rate, and all projects with returns at or above that
interest rate will be funded; the projects with expected returns
below the interest rate will not be funded. In this way, the
economy gets the most “bang” (future productive capacity) out
of its investment “buck.” Just another reason why capitalism is
such a beautiful thing!
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.
classroom use.
‹#›
classroom use.
‹#›
33
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.
classroom use.
‹#›
classroom use.
‹#›
34
Policy 3: Govt Budget Deficits
Interest
Rate
D1
A budget deficit reduces national saving and the supply of L.F.
S1

5%
60
S2
…which increases the eq’m interest rate
and decreases the eq’m quantity of L.F.
6%
50
‹#›
classroom use.
‹#›
35
35
This slide is “hidden” and will not appear in the slide show
presentation. I provided it in case you wish to lecture on the
effects of budget deficits instead of having students do the
analysis themselves in the exercise from Active Learning 2. If
so, move this slide to that location and “unhide” this slide, by
unselecting “hide” in the Slide Show menu.
The analysis shows that the budget deficit reduces investment,
which the preceding chapter shows is important for the long-run
standard of living. This is one reason why many economists
believe budget deficits are generally undesirable.

In the real world, we sometimes see increases in government
budget deficits that are not accompanied by dollar-for-dollar
decreases in investment, as the analysis on this slide would
predict. Keep in mind, however, that the analysis here is for the
closed economy model. In an open economy, firms can finance
investment by borrowing from abroad in the face of a decrease
in the domestic supply of loanable funds.
This, of course, does not mean that budget deficits are “okay” in
an open economy, because the extra indebtedness requires
service, such as interest or dividend payments, which reduces
the amount of income remaining for residents of the country.
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