ARSI UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

Department of Management
SECOND YEAR SECOND SEMESTER

Course Title: MACROECONOMICS

Course Code: Econ 2031

"SAVING, INVESTMENT &

THE FINANCIAL SYSTEM"

Group Assignment l

Group Member ID NO

1, Gemechu Bobaso --------------------------------- Ugr/15220/16

2, Gemechu Kebebe ----------------------------------Ugr/15221/16

3, Hasen Abdurahman -------------------------------Ugr/15226/16

4, Henok Merehatsidik ------------------------------ Ugr/14886/16

5, Jango Bobaso ----------------------------------------Ugr/15231/16

6, Ibrahim Jara ------------------------------------------ Ugr/15720/16

7, Iftu Regassa ------------------------------------------- Ugr/15727/16

Instructor Name: Mr. Eyob

JUN 2025

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 Table of content Page

◉ Saving, Investment and the Financial System ********************3

◉Introduction*******************************************************3
1.1 Financial System***********************************************3

1.1.1 Functions of Financial System *****************************4

1.1.2 Role and Importance of Financial System ******************5

1.1.3 Components of Financial System **************************5

1.2 Financial Institution ********************************************6

1.2.1 Types of Financial Institutions*****************************7

1.3 Financial Market **********************************************7

1.3.1 Capital Market *********************************************11

1.3.2 Money Market *********************************************11

1.4 Financial Intermediaries ************************************** 13

1.5 Saving And Investment in the National Income Account ****** 13

1.6 The Market for Loanable Funds *******************************15

1.6.1 Supply And Demand for Loanable Funds ******************16

1.6.2 Policies ************************************************** 17

Summary *********************************************************19

Reference ********************************************************20

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 SAVING, INVESTMENT AND THE FINANCIAL SYSTEM
INTRODUCTION

This chapter explores the fundamental role of saving and investment in a nation's
economy and how financial systems channel resources from savers to borrowers. It
provides a detailed understanding of financial institutions, markets, and the national
income accounts that capture the dynamics of saving and investment.

Objectives of the Topic

➪Understand how saving and investment interact within the economy.

➪Analyze the role of financial institutions and markets.

➪Understanding the loanable funds

➪Assess the impact of government policy on saving and investment.

1.1 FINANCIAL SYSTE

➨A Financial System may be Defined as a set of Institutions, Instruments, and Markets
which encourage savings and channelize them to their effective use".

➨Financial System is a System that allows the Exchange of Funds between Financial
Market Participants Borrowers. Such as Lenders, and Investors.

➨A Financial System is a set of Institutions such as Banks, Insurance Companies, and

Stock Exchanges that Permit the Exchange of Funds.

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1.1.1 FUNCTIONS OF FINANCIAL SYSTEM
➨The financial system of a country performs certain valuable functions for the
economic growth of that country. The main functions of a financial system may be
briefly discussed as below;

1. Intermediation: Financial systems act as intermediaries between savers and

borrowers, channeling funds from those who have excess funds (savers) to those who
need funds (borrowers). This intermediation process facilitates the efficient allocation
of capital and promotes economic growth.

2. Mobilization of savings: Financial systems provide a mechanism for individuals and

businesses to save money and earn a return on their savings. Through banks,
investment funds, and other financial institutions, savings are pooled together and
made available for productive investments.

3. Facilitation of investments: Financial systems enable individuals, businesses, and

governments to access the capital needed for investment in productive activities. They
provide various investment options such as stocks, bonds, and venture capital, allowing
entities to raise funds to expand operations, launch new projects, or develop
infrastructure.

4. Risk management: Financial systems offer a range of risk management tools and
instruments, such as insurance, derivatives, and hedging strategies. These mechanisms
help individuals and businesses mitigate risks associated with fluctuations in interest
rates, exchange rates, commodity prices, and other market uncertainties.

5. Price discovery: Financial markets provide a platform for trading financial

instruments, allowing buyers and sellers to determine fair prices based on supply and
demand dynamics. This price discovery process ensures transparency and efficiency in
the valuation of assets and facilitates the efficient allocation of resources.

6. Facilitation of payments: Financial systems enable the smooth and secure transfer
of funds between individuals, businesses, and institutions. They provide payment
systems, such as electronic funds transfer, credit cards, and digital wallets, which
facilitate the settlement of transactions and support economic activities.

7. Capital Formation: Financial systems play a crucial role in capital accumulation

within an economy. By mobilizing savings, facilitating investments, and promoting
efficient allocation of capital, they contribute to capital stock growth, which is essential
for long-term economic development.

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8. Monetary policy implementation: Central banks implement monetary policy as part
of the financial system by controlling the economy's money supply, interest rates, and
liquidity. They regulate and stabilize the financial system, ensuring price stability and
fostering macroeconomic stability.

9. Financial inclusion: Financial systems aim to promote financial inclusion by providing

access to financial services for individuals and businesses, including those in
underserved or marginalized communities. This fosters economic participation, poverty
reduction, and social development.

1.1.2 ROLE AND IMPORTANCE OF FINANCIAL SYSTEM

The financial system plays a vital role in the economy by mobilizing savings, allocating
capital efficiently, and facilitating productive investments.

➪ It provides services that enable smooth financial transactions.

➪ It facilitates price discovery and information dissemination.
➪ It Supports economic stability through risk management and financial
intermediation.

➪ Financial systems are crucial for economies as they promote economic growth.
➪ They enable individuals and institutions to save, invest, manage risks, and conduct
transactions efficiently.

➪ Financial systems also play a role in price discovery, ensuring fair prices for assets
and commodities.

➪ They contribute to economic stability, support monetary policy, and help regulate
financial activities.

1.1.3 COMPONENTS OF FINANCIAL SYSTEM

The financial system is made up of several interconnected components. These include
financial institutions, markets, services, instruments, and money, all working together to
facilitate the flow of funds between lenders and borrowers. Other important
components include central banks, government policy, risk management, and
regulatory,bodies.

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1. Financial Institutions: These are the organizations that facilitate financial
transactions, such as commercial banks, investment banks, and insurance companies.

2. Financial Markets: These are organized venues where financial instruments are
traded, including stock exchanges, bond markets, and foreign exchange markets.

3. Financial Services: These are the services provided by financial institutions, such as
banking, investment management, and insurance.

4. Financial Instruments: These are the tools used to facilitate the transfer of funds,
such as stocks, bonds, and derivatives.

5. Money: The medium of exchange used in financial transactions.

6. Central Banks: These are the institutions responsible for setting monetary policy and
regulating the financial system.

7. Government Policy: Government regulations and policies that impact the financial
system, such as tax laws and financial regulations.

8. Risk Management: The processes and strategies used to identify, assess, and
manage financial risks.

9. Regulatory Bodies: These are the agencies that oversee and regulate the financial
system, ensuring compliance with laws and regulations.

1.2 FINANCIAL INSTITUTION

A financial institution (FI) is a company engaged in the business of dealing with
financial and monetary transactions such as deposits, loans, investments, and currency
exchange. Financial institutions are vital to a functioning capitalist economy in
matching people seeking funds with those who can lend or invest it.

➨Financial institutions are firms that provide financial services, such as taking deposits,
making loans, and investing funds.

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1.2.1 Types of Financial Institutions
1. Commercial Banks: A commercial bank is a financial institution that provides
services like loans, certificates of deposits, savings bank accounts bank overdrafts, etc.
to its customers. These institutions make money by lending loans to individuals and
earning interest on loans. Various types of loans given by a commercial bank are;
business loans, car loans, house loans, personal loans, and education loans.

➨According to the commercial bank definition, it is a financial institution whose

purpose is to accept deposits from customers and lend out loans.

➨Public sector banks, private sector banks, and regional rural banks are the types of
commercial banks.

2. Investment Banks: Investment banking is a special segment of banking operation

that helps individuals or organizations raise capital and provide financial consultancy
services to them.

➨They act as intermediaries between security issuers and investors and help new firms
to go public. They either buy all the available shares at a price estimated by their experts

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and resell them to public or sell shares on behalf of the issuer and take commission on
each share.

3. Insurance Companies: Insurance companies are businesses that provide financial

protection against potential losses by agreeing to compensate policyholders for
covered events in exchange for a fee, called a premium. They essentially take on the
risk of unforeseen events happening to individuals or businesses, and in return, offer
financial support.

Types of Insurance

➨Insurance companies offer a wide variety of insurance products, including:

➽.Life Insurance: Provides financial support to beneficiaries upon the death of the
insured.

➽ Health Insurance: Covers medical expenses.

➽ Property Insurance: Protects against damage or loss to property.
➽ Automobile Insurance: Covers damages or losses related to vehicle accidents.
➽ Liability Insurance: Protects against legal liabilities.

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4. Pension Funds: A pension fund is a type of investment account specifically designed
to provide retirement income. It works by accumulating contributions, typically from
employers and/or employees, which are then invested and allowed to grow over time.
Upon retirement, members of the fund receive benefits, often in the form of regular
payments or a lump sum, based on the accumulated value of their contributions.

Example: Bank Loan Process A bank accepts deposits from the public and uses
those funds to make loans to businesses, earning interest in return.

1.3 FINANCIAL MARKET

Financial Markets include any place or system that provides buyers and sellers the
means to trade financial instruments, including bonds, equities, the various international
currencies, and derivatives. Financial markets facilitate the interaction between those
who need capital with those who have capital to invest.

➨Financial Market, for credit and capital, can be divided into the Money Market and the
Capital Market serving different investor preferences.

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1.3.1 Capital Market
A capital market is a financial marketplace where buyers and sellers trade long-term
debt and equity securities. Essentially, it's a place where businesses and governments
raise capital by issuing stocks, bonds, and other financial instruments, and investors
can buy and sell these instruments to earn returns.it has two branches. These are;

A. Stock Market: The stock market is where investors buy and sell shares of
companies, also known as stocks. The stock market is a set of exchanges where
companies issue shares and other securities for trading.

➨Stock markets allow investors to invest their money in market-linked instruments

and gain inflation-beating returns. Long-term investment in the stock market can help
investors grow their wealth due to capital appreciation.

➨Stock markets are organized platforms where buyers and sellers come together to
trade shares of publicly listed companies. At their core, these markets operate on the
principle of supply and demand, with share prices fluctuating based on companies'
perceived value and overall market conditions.

B. Bond Market: The bond market encompasses the marketplace where debt
securities are issued, bought, and sold between entities seeking capital and those
looking to invest. As one of the largest financial markets globally, it plays a crucial role
in economic stability and growth.

➨They are not exposed to stock volatility in the market. Capital Preservation: Bonds
tend to be less fluctuant than stocks and, therefore, more attractive to investors
because of their perceived ability to secure their capital, particularly for risk-averse or
short-term investors.

1.3.2 Money Market

A money market is a financial market where short-term debt securities and instruments
are traded. It provides a way for businesses and governments to raise short-term capital,
and for investors to earn returns on their money in a relatively low-risk environment.
These instruments are generally liquid and have a maturity of one year or less.

1.4 Financial Intermediaries

➪Financial intermediaries are an important component of the financial system of a
country.

➪Financial intermediation refers to the practice of linking an investor and borrower.

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➪Financial intermediaries are banking(Central banks and Commercial banks) and non-
banking institutions (insurance companies. mutual trust funds, investment companies,
pension funds and discount houses) which transfer funds from economic agents with
surplus funds (surplus units) to economic agents (deficit units) that would like to utilize
those funds.

➪A financial system comprises institutions, markets, instruments, and regulations that

facilitate the flow of funds between savers and investors. It plays a critical role in
promoting economic efficiency by allocating resources to their most productive uses,
reducing transaction costs, and spreading risk.

➪A financial system is a network of institutions and markets that facilitate the

movement of funds between those who have savings (lenders) and those who need
funds (borrowers). It's crucial for economic growth by enabling efficient resource
allocation, facilitating payments, and managing risk.

1.5 SAVING AND INVESTMENT iN THE NATIONAL INCOME ACCOUNT

➨ National income accounts are a system of economic measurement that records a
nation's production, income, and expenditure. Saving and investment are key
components of national income, with saving providing the funds for investment.
Investment, in turn, contributes to economic growth and capital accumulation.

➨National income account is a set of statistical data that tracks a country's economic
activity, including production, income, and spending.

➨They serve as a tool to measure the overall health of an economy, track economic
growth, and understand the relationship between different economic sectors.

1.5.1 Main Components

Gross Domestic Product (GDP): The total market value of all final goods and services
produced within a country's borders in a given period.

National Income: The total income earned by a country's residents in a given period.

Consumption: The expenditure by households on goods and services.

Investment: The expenditure by businesses on capital goods, such as machinery and

equipment.

Government Spending: The expenditure by the government on goods and services.

Net Exports: The difference between a country's exports and imports.

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➨In essence, national income accounts provide a framework for understanding the flow
of economic activity within a country, and saving and investment are crucial
components of this flow, influencing economic growth and development.

➨In national income accounting, saving and investment are related through the national
income identity. National saving, which is the sum of private and public saving, is equal
to total income minus consumption and government spending. Investment, on the other
hand, is derived from the GDP equation and is essentially the amount of income left
after consumption and government spending. The difference between national savings
and investment is the current account.

➥National Income Identity: This identity, which is a fundamental relationship in

macroeconomics, states that a nation's GDP (which is its total income) is equal to the
sum of consumption, government spending, and investment. This means that the level
of saving is directly linked to the level of investment in a closed economy.

➥National Savings: This represents the portion of a nation's income that is not used
for current consumption and government spending. It's a crucial element for long-term
economic growth, as it provides resources for investment and future production.

National Saving = Private + Public Saving

➨Saving: Refers to income that is not spent on consumption, but rather set aside for
future use.

➥Private saving: This refers to the portion of household income that is not spent on
consumption or taxes.

Private Saving = Y - T - C
➥Public saving: This is the difference between government revenue (primarily taxes)
and government spending.

Public Saving = T - G

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Pros and Cons of Saving

Pros
➪It builds up an emergency fund.
➪It funds short-term or long-term goals, like going on a vacation.
➪There's minimal risk of loss. Savings held at banks are protected by the FDIC.

Cons
➪There's much lower yields.
➪It may lose out to inflation.
➪There are opportunity costs when not invested in riskier but higher yielding assets.
Investment: refers to the spending on capital goods, like machinery and buildings, which
are used to produce future output. It's also a key driver of economic growth.

➨Investment: Refers to the expenditure on capital goods, such as machinery and

equipment, or on new construction.

In a closed economy, I = S.

N.B Savings provide the funds that are available for investment. Investment, in turn,
contributes to economic growth and increases the stock of capital in the economy.

➨Higher levels of saving and investment can lead to increased economic growth,
higher living standards, and increased productivity over time.

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Pros and Cons of Investing

Pros

➪Potential for higher returns than savings

➪Can help achieve long-term financial goals
➪Diversification can reduce risk
Cons

➪Risk of loss, especially in the short-run

➪Requires discipline and commitment
➪May require longer time horizons
Numerical Example 1: 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.

Given:

Y = 10.0, C = 6.5,

G = 2.0, G – T = 0.3

Solution

A. Public saving = T – G = – 0.3

B. Taxes: T = G – 0.3 = 1.7

C. Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8

D. National saving = Y – C – G = 10 – 6.5 = 2 = 1.5

E. Investment = national saving = 1.5

Example 2: 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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Answer for example 2: 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.

1.6 The Market for Loanable Funds

➨The market for loanable funds is a macroeconomic concept that describes how
borrowers and lenders interact to determine interest rates. It's a market where
individuals and businesses can borrow money, and where savers can lend money,
essentially connecting those who have excess funds with those who need to borrow
them.

➨The loanable funds market is a conceptual framework that helps explain how interest
rates are determined. It's not a physical marketplace, but rather a description of the
interaction between supply and demand for credit.

Key Participants

1. Lenders (Savers): Individuals or institutions who have funds available to lend, like
households saving money for retirement, a blog post by Peter Clark says. They are the
supply side of the market.

2. Borrowers: Businesses, individuals, or governments who need to borrow money for

investment, consumption, or other purposes. They are the demand side of the market.

1.6.1 SUPPLY AND DEMAND FOR LOANABLE FUNDS

Supply of Loanable Funds: The supply of loanable funds is influenced by the amount of
saving households and businesses do, as well as government policies (e.g., tax cuts can
increase saving). A higher supply of loanable funds generally leads to lower interest
rates.

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Demand for Loanable Funds: The demand for loanable funds is determined by
businesses' investment plans, households' consumption spending, and government
borrowing. A higher demand for loanable funds generally leads to higher interest rates.

➪Interest Rates: The interest rate is the price of borrowing money. It's determined
by the interaction of supply and demand in the loanable funds market. A higher interest
rate means borrowing becomes more expensive, and may discourage borrowing.

FACTORS THAT SHIFT THE SUPPLY AND DEMAND CURVES

Shifts in Supply

Changes in savings behavior (e.g., increased savings due to a recession), shifts in

government policy (e.g., tax cuts that encourage saving), or changes in demographics
(e.g., an aging population with more retirees) can shift the supply curve.

Shifts in Demand

Changes in business investment plans (e.g., optimism about future growth), changes in
government spending, or shifts in consumer confidence (e.g., increased optimism about
the future) can shift the demand curve.

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IMPACT OF CHANGES IN INTEREST RATES

Lower interest rates

Can lead to increased borrowing, stimulating investment and potentially increasing

economic activity. However, lower interest rates can also encourage speculation and
potentially lead to asset bubbles.

Higher interest rates

Can discourage borrowing, potentially slowing down economic activity. However, higher
interest rates can also help to control inflation and stabilize the economy.

Example: If the government increases its borrowing to fund public projects, it will
increase the demand for loanable funds, potentially leading to higher interest rates. This
could make it more expensive for businesses to borrow money for investment,
potentially slowing down economic growth, according to a study by the International
Monetary Fund.

1.6.2 POLICIES
Some government policies, such as investment tax credits, basically lower the cost of
borrowing money at every real interest rate. Such policies would increase the demand
for loanable funds. Other policies, such as tax and saving, tax and investment,
government budget deficits and surpluses, might increase the demand for loanable
funds.

Policy 1. Taxes and Saving: When the government changes the tax treatment of
saving (e.g., tax incentives for saving such as tax-free retirement accounts or reduced
taxes on interest income).

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Effect on the Loanable Funds Market:

➪Increased incentive to save → Supply of loanable funds increases.

➪Supply curve shifts right.
➪Real interest rate falls.
➪Quantity of loanable funds increases → more funds available for investment.
Example: Tax exemptions on savings accounts make people save more, increasing
the supply of funds in banks.

Policy 2. Taxes and Investment: Changes in tax laws that affect the return on
investment, such as investment tax credits.

Effect on the Loanable Funds Market:

➪Increased incentive to invest → Demand for loanable funds increases.

➪Demand curve shifts right.
➪Real interest rate rises.
➪Quantity of loanable funds increases → more investment projects are financed.
Example: A tax credit for building factories encourages firms to borrow more,
increasing demand for funds.

Policy 3. Government Budget Deficit and Surplus: Government's borrowing behavior

(whether it runs a deficit or a surplus).

Effect on the Loanable Funds Market:

Government Budget Deficit:

➪The government borrows from the loanable funds market.

➪Reduces the supply of loanable funds available to the private sector.
➪Supply curve shifts left.
➪Real interest rate rises.
➪Crowding out occurs – private investment is reduced.
Government Budget Surplus:

➪Government saves more or borrows less.

➪Increases the supply of loanable funds.

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➪Supply curve shifts right.
➪Real interest rate falls.
➪Investment increases.
Example: When the government runs a deficit to finance spending, it competes with
businesses for loanable funds, which drives up interest rates.

SUMMARY

In general, saving, investment, and the financial system are fundamental components of
a well-functioning economy. Saving provides the funds necessary for investment, which
in turn drives economic growth by increasing capital stock and productivity. The
financial system—comprising institutions like banks, bond markets, and stock
markets—plays a crucial role in channeling resources from savers to borrowers,
ensuring that funds are allocated efficiently. By facilitating the flow of money and
supporting investment, the financial system strengthens economic stability and growth,
making it an essential pillar of both short-term financial management and long-term
development.

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REFERENCES

◉N.Gregory Mankiw.(2020). Principles of Economics (7th ed.).pdf

◉Krugman, P., & Wells, R. (2018). Macroeconomics (5th ed.)
◉Blanchard, O. (2017). Macroeconomics (7th ed.).
◉Mishkin, F. S. (2018). The Economics of Money, Banking, and Financial Markets (12th
ed.)

◉https://www.investopedia.com/articles/investing/022516/saving-vs-investing
◉ N. Gregory Mankiw "Saving, Investment, and the Financial System" ppt

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