ECONOMICS

Twelfth Edition, Global Edition

Chapter 24
Finance, Saving,
and Investment

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 Chapter Outline and Learning Objectives

24.1 Describe the flow of funds

in financial markets
24.2 Explain how saving and
investment decisions interact in
financial markets
24.3 Explain how governments
influence financial markets

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 Financial Institutions and Financial
Markets (1 of 9)
• To study the economics of financial institutions and
markets we distinguish between
‒ Finance and money
‒ Physical capital and financial capital
• Finance and Money
‒ The study of finance looks at how households and firms obtain
and use financial resources and how they cope with the risks that
arise in this activity.
‒ The study of money looks at how households and firms use it, how
much of it they hold, how banks create and manage it, and how its
quantity influences the economy.

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 Financial Institutions and Financial
Markets (2 of 9)
• Capital and Financial Capital
‒ Capital (or physical capital) is the tools, instruments, machines,
buildings, and other items that have been produced in the past
and that are used today to produce goods and services.
‒ The funds that firms use to buy physical capital are called
financial capital.

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 Financial Institutions and Financial
Markets (3 of 9)
• Capital and Investment
• Gross investment is the total amount spent on purchases of new
capital and on replacing depreciated capital.
• Depreciation is the decrease in the quantity of capital that results
from wear and tear and obsolescence.
• Net investment is the change in the quantity of capital.
Net investment = Gross investment − Depreciation.

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 Financial Institutions and Financial
Markets (4 of 9)
• Figure 24.1 illustrates the
relationships among the
capital, gross investment,
depreciation, and net
investment.

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 Financial Institutions and Financial
Markets (5 of 9)
• Wealth and Saving
‒ Wealth is the value of all the things that people own.
‒ Saving is the amount of income that is not paid in taxes or spent
on consumption goods and services.
‒ Saving increases wealth.
‒ Wealth also increases when the market value of assets rises—
called capital gains—and decreases when the market value of
assets falls—called capital losses.

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 Financial Institutions and Financial
Markets (6 of 9)
• Financial Capital Markets
‒ Saving is the source of funds used to finance investment.
‒ These funds are supplied and demanded in three types of
financial markets:
▪ Loan markets
▪ Bond markets
▪ Stock markets

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 Financial Institutions and Financial
Markets (7 of 9)
• Financial Institutions
‒ A financial institution is a firm that operates on both sides of the
markets for financial capital.
‒ It is a borrower in one market and a lender in another.
‒ Key financial institutions are
▪ Commercial banks
▪ Government-sponsored mortgage lenders
▪ Pension funds
▪ Insurance companies
▪ The Federal Reserve

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 Financial Institutions and Financial
Markets (8 of 9)
• Insolvency and Illiquidity
‒ A financial institution’s net worth is the total market value of what
it has lent minus the market value of what it has borrowed.
‒ If net worth is positive, the institution is solvent and can remain in
business.
‒ But if net worth is negative, the institution is insolvent and will go
out of business.

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 Financial Institutions and Financial
Markets (9 of 9)
• Interest Rates and Asset Prices
‒ The interest rate on a financial asset is the interest received
expressed as a percentage of the price of the asset.
‒ For example, if the price of the asset is $50 and the interest is $5,
then the interest rate is 10 percent.
‒ If the asset price rises (say to $200), other things remaining the
same, the interest rate falls (2.5 percent).
‒ If the asset price falls (say to $20), other things remaining the
same, the interest rate rises (to 25 percent).

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 The Loanable Funds Market (1 of 17)

• The market for loanable funds is the aggregate of all the

individual financial markets.
• Funds that Finance Investment
‒ Funds come from three sources:
▪ Household saving S
▪ Government budget surplus (T – G)
▪ Borrowing from the rest of the world (M – X)

• Figure 24.2 on the next slide illustrates the flows of funds

that finance investment.

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 The Loanable Funds Market (2 of 17)

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 The Loanable Funds Market (3 of 17)

• The Real Interest Rate

‒ The nominal interest rate is the number of dollars that a borrower
pays and a lender receives in interest in a year expressed as a
percentage of the number of dollars borrowed and lent.
‒ For example, if the annual interest paid on a $500 loan is $25, the
nominal interest rate is 5 percent per year.

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 The Loanable Funds Market (4 of 17)

• The real interest rate is the nominal interest rate adjusted

to remove the effects of inflation on the buying power of
money.
• The real interest rate is approximately equal to the nominal
interest rate minus the inflation rate.
• For example, if the nominal interest rate is 5 percent a year
and the inflation rate is 2 percent a year, the real interest
rate is 3 percent a year.
• The real interest rate is the opportunity coast of borrowing.

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 The Loanable Funds Market (5 of 17)

• The market for loanable funds determines the real interest

rate, the quantity of funds loaned, saving, and investment.
• We’ll start by ignoring the government and the rest of the
world.
• The Demand for Loanable Funds
‒ The quantity of loanable funds demanded depends on
▪ The real interest rate
▪ Expected profit

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 The Loanable Funds Market (6 of 17)

• Demand for Loanable Funds Curve

‒ The demand for loanable funds is the relationship between the
quantity of loanable funds demanded and the real interest rate
when all other influences on borrowing plans remain the same.
‒ Business investment is the main item that makes up the demand
for loanable funds.

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 The Loanable Funds Market (7 of 17)

• Figure 24.3 shows the

demand for loanable
funds curve.
• A rise in the real
interest rate decreases
the quantity of loanable
funds demanded.
• A fall in the real interest
rate increases the
quantity of loanable
funds demanded.

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 The Loanable Funds Market (8 of 17)

• Changes in the Demand for Loanable Funds

‒ When the expected profit changes, the demand for loanable funds
changes.
‒ Other things remaining the same, the greater the expected profit
from new capital, the greater is the amount of investment and the
greater the demand for loanable funds.

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 The Loanable Funds Market (9 of 17)

• The Supply of Loanable Funds

‒ The quantity of loanable funds supplied depends on
▪ The real interest rate
▪ Disposable income
▪ Expected future income
▪ Wealth
▪ Default risk

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 The Loanable Funds Market (10 of 17)

• The Supply of Loanable Funds Curve

‒ The supply of loanable funds is the relationship between the
quantity of loanable funds supplied and the real interest rate when
all other influences on lending plans remain the same.
‒ Saving is the main item that makes up the supply of loanable
funds.

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 The Loanable Funds Market (11 of 17)

• Figure 24.4 shows the

supply of loanable funds
curve.
• A rise in the real interest
rate increases the
quantity of loanable funds
supplied.
• A fall in the real interest
rate decreases the
quantity of loanable funds
supplied.

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 The Loanable Funds Market (12 of 17)

• Changes in the Supply of Loanable Funds

‒ A change in disposable income, expected future income, wealth,
or default risk changes the supply of loanable funds.
‒ An increase in disposable income, a decrease in expected future
income, a decrease in wealth, or a fall in default risk increases
saving and increases the supply of loanable funds.

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 The Loanable Funds Market (13 of 17)

• Equilibrium in the Loanable Funds Market

‒ The loanable funds market is in equilibrium at the real interest rate
at which the quantity of loanable funds demanded equals the
quantity of loanable funds supplied.

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 The Loanable Funds Market (14 of 17)

• Figure 24.5 illustrates the

loanable funds market.
• At 7 percent a year, there is
a surplus of funds and the
real interest rate falls.
• At 5 percent a year, there is
a shortage of funds and the
real interest rate rises.
• Equilibrium occurs at a real
interest rate of 6 percent a
year.

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 The Loanable Funds Market (15 of 17)

• Changes in Demand and Supply

‒ Financial markets are highly volatile in the short run but
remarkably stable in the long run.
‒ Volatility comes from fluctuations in either the demand for loanable
funds or the supply of loanable funds.
‒ These fluctuations bring fluctuations in the real interest rate and in
the equilibrium quantity of funds lent and borrowed.
‒ They also bring fluctuations in asset prices.

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 The Loanable Funds Market (16 of 17)

• Figure 24.6(a) illustrates

an increase in the
demand for loanable
funds.
• An increase in expected
profits increases the
demand for funds today.
• The real interest rate
rises.
• Saving and quantity of
funds supplied increases.

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 The Loanable Funds Market (17 of 17)

• Figure 24.6(b) illustrates

an increase in the supply
of loanable funds.
• If one of the influences on
saving plans changes and
saving increases, the
supply of funds increases.
• The real interest rate falls.
• Investment increases.

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 Government in the Loanable Funds
Market (1 of 4)
• Government enters the loanable funds market when it has
a budget surplus or deficit.
‒ A government budget surplus increases the supply of funds.
‒ A government budget deficit increases the demand for funds.

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 Government in the Loanable Funds
Market (2 of 4)
• Figure 24.7 illustrates the
effect of a government
budget surplus.
• A government budget
surplus increases the supply
of funds.
• The real interest rate falls.
• Private saving decreases.
• Investment increases.

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 Government in the Loanable Funds
Market (3 of 4)
• Figure 24.8 illustrates the
effect of a government
budget deficit.
• A government budget deficit
increases the demand for
funds.
• The real interest rate rises.
• Private saving increases.
• Investment decreases—is
crowded out.

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 Government in the Loanable Funds
Market (4 of 4)
• Figure 24.9 illustrates the
Ricardo-Barro effect.
• A budget deficit increases
the demand for funds.
• Rational taxpayers
increase saving, which
increases the supply of
funds.
• Increased private saving
finances the deficit.
• Crowding-out is avoided.
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