Saving, Investment, and the

Financial System
THE FINANCIAL SYSTEM
• The financial system consists of the group of
institutions in the economy that help to match
one person’s saving with another person’s
investment.
• It moves the economy’s scarce resources from
savers to borrowers.
FINANCIAL INSTITUTIONS
• The financial system is made up of financial
institutions that coordinate the actions of savers
and borrowers.
• Financial institutions can be grouped into two
different categories:
• Financial markets and
• Financial intermediaries.
FINANCIAL INSTITUTIONS
• Financial Markets
• Stock Market
• Bond Market
• Financial Intermediaries
• Banks
• Mutual Funds
FINANCIAL INSTITUTIONS
• Financial markets are the institutions through
which savers can directly provide funds to
borrowers.
• Financial intermediaries are financial institutions
through which savers can indirectly provide
funds to borrowers.
The Bond Market
• A bond is a certificate of acknowledgment
that specifies obligations of the borrower to
the holder of the bond.
• Characteristics of a Bond
• Term: The length of time until the bond matures.
• Credit Risk: The probability that the borrower
will fail to pay some of the interest or principal.
• Tax Treatment: The way in which the tax laws
treat the interest on the bond.
• Municipal bonds are federal tax exempt.
The Stock Market
• Stock represents a claim to partial ownership in
a firm and is therefore, a claim to the profits
that the firm makes.
• The sale of stock to raise money is called equity
financing.
• Compared to bonds, stocks offer both higher
risk and potentially higher returns.
• The most important stock exchanges in
Bangladesh is Dhaka Stock exchange and
Chittagong Stock exchange and in the United
States are the New York Stock Exchange, the
American Stock Exchange, and NASDAQ.
The Stock Market
• Most newspaper stock tables provide the
following information:
• Price (of a share)
• Volume (number of shares sold)
• Dividend (profits paid to stockholders)
• Price-earnings ratio
Financial intermediaries
• Financial intermediaries are financial institutions
through which savers can indirectly provide
funds to borrowers.
 Banks
• Banks
• take deposits from people who want to save
and use the deposits to make loans to people
who want to borrow.
• pay depositors interest on their deposits and
charge borrowers slightly higher interest on
their loans.
 Banks
• Banks help create a medium of exchange
by allowing people to write checks
against their deposits.
• A medium of exchanges is an item that
people can easily use to engage in
transactions.
• This facilitates the purchases of goods
and services.
Mutual Funds
• Mutual Funds
• A mutual fund is an institution that sells
shares to the public and uses the
proceeds to buy a portfolio, of various
types of stocks, bonds, or both.
• They allow people with small amounts of
money to easily diversify.
Other Financial Institutions
• Credit unions
• Pension funds
• Insurance companies
• Loan sharks
SAVING AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
• Recall that GDP is both total income in an
economy and total expenditure on the
economy’s output of goods and services:
Y = C + I + G + NX
Some Important Identities

• Assume a closed economy – one that does not

engage in international trade:

Y=C+I+G
Some Important Identities

• Now, subtract C and G from both sides of the

equation:
Y – C – G =I
• The left side of the equation is the total income
in the economy after paying for consumption
and government purchases and is called national
saving, or just saving (S).
Some Important Identities

• Substituting S for Y - C - G, the equation can be

written as:
S=I
Some Important Identities

• National saving, or saving, is equal to:

S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
The Meaning of Saving and Investment

• National Saving
• National saving is the total income in the
economy that remains after paying for
consumption and government purchases.
• Private Saving
• Private saving is the amount of income that
households have left after paying their taxes
and paying for their consumption.
Private saving = (Y – T – C)
The Meaning of Saving and Investment

• Public Saving
• Public saving is the amount of tax revenue that
the government has left after paying for its
spending.
Public saving = (T – G)
The Meaning of Saving and Investment

• Surplus and Deficit

• If T > G, the government runs a budget surplus
because it receives more money than it
spends.
• The surplus of T - G represents public saving.
• If G > T, the government runs a budget deficit
because it spends more money than it receives
in tax revenue.
The Meaning of Saving and Investment

• For the economy as a whole, saving must be

equal to investment.
S=I
THE MARKET FOR LOANABLE
FUNDS
• Financial markets coordinate the economy’s
saving and investment in the market for loanable
funds.
THE MARKET FOR LOANABLE
FUNDS
• The market for loanable funds is the market in
which those who want to save supply funds and
those who want to borrow to invest demand
funds.
THE MARKET FOR LOANABLE
FUNDS
• Loanable funds refers to all income that people
have chosen to save and lend out, rather than
use for their own consumption.
Supply and Demand for Loanable Funds

• The supply of loanable funds comes from people

who have extra income they want to save and
lend out.
• The demand for loanable funds comes from
households and firms that wish to borrow to
make investments.
Supply and Demand for Loanable Funds

• The interest rate is the price of the loan.

• It represents the amount that borrowers pay for
loans and the amount that lenders receive on
their saving.
• The interest rate in the market for loanable funds
is the real interest rate.
Supply and Demand for Loanable Funds

• Financial markets work much like other markets

in the economy.
• The equilibrium of the supply and demand for
loanable funds determines the real interest
rate.
Figure 1 The Market for Loanable Funds

Interest
Rate Supply

5%

Demand

0 $1,200 Loanable Funds

(in billions of dollars)
Supply and Demand for Loanable Funds

• Government Policies That Affect Saving and

Investment
• Taxes and saving
• Taxes and investment
• Government budget deficits
Policy 1: Saving Incentives

• Taxes on interest income substantially reduce the

future payoff from current saving and, as a
result, reduce the incentive to save.
Policy 1: Saving Incentives

• A tax decrease increases the incentive for

households to save at any given interest rate.
• The supply of loanable funds curve shifts to
the right.
• The equilibrium interest rate decreases.
• The quantity demanded for loanable funds
increases.
Figure 2 An Increase in the Supply of Loanable Funds

Interest Supply, S1 S2
Rate

1. Tax incentives for

5%
saving increase the
supply of loanable
4%
funds . . .

2. . . . which Demand
reduces the
equilibrium
interest rate . . .

0 $1,200 $1,600 Loanable Funds

(in billions of dollars)
3.. . . and raises the equilibrium
quantity of loanable funds.
Policy 1: Saving Incentives

• If a change in tax law encourages greater saving,

the result will be lower interest rates and greater
investment.
Policy 2: Investment Incentives

• An investment tax credit increases the incentive

to borrow.
• Increases the demand for loanable funds.
• Shifts the demand curve to the right.
• Results in a higher interest rate and a greater
quantity saved.
Policy 2: Investment Incentives

• If a change in tax laws encourages greater

investment, the result will be higher interest
rates and greater saving.
 Figure 3 An Increase in the Demand for Loanable
Funds
Interest
Rate Supply
1. An investment
tax credit
6% increases the
demand for
5% loanable funds . . .

2. . . . which
raises the D2
equilibrium
interest rate . . . Demand, D1

0 $1,200 $1,400 Loanable Funds

(in billions of dollars)
3. . . . and raises the equilibrium
quantity of loanable funds.
Policy 3: Government Budget Deficits and
Surpluses
• When the government spends more than it
receives in tax revenues, the short fall is called
the budget deficit.
• The accumulation of past budget deficits is called
the government debt.
Policy 3: Government Budget Deficits and
Surpluses
• Government borrowing to finance its budget
deficit reduces the supply of loanable funds
available to finance investment by households
and firms.
• This fall in investment is referred to as crowding
out.
• The deficit borrowing crowds out private
borrowers who are trying to finance
investments.
Policy 3: Government Budget Deficits and
Surpluses
• A budget deficit decreases the supply of loanable
funds.
• Shifts the supply curve to the left.
• Increases the equilibrium interest rate.
• Reduces the equilibrium quantity of loanable
funds.
 Figure 4: The Effect of a Government Budget Deficit

Interest S2
Rate Supply, S1

1. A budget deficit
6%
decreases the
5% supply of loanable
funds . . .

2. . . . which
raises the
equilibrium Demand
interest rate . . .

0 $800 $1,200 Loanable Funds

(in billions of dollars)
3. . . . and reduces the equilibrium
quantity of loanable funds.
Policy 3: Government Budget Deficits and
Surpluses
• When government reduces national saving by
running a deficit, the interest rate rises and
investment falls.
Policy 3: Government Budget Deficits and
Surpluses
• A budget surplus increases the supply of
loanable funds, reduces the interest rate, and
stimulates investment.