Name _______________________
Unit 5: Financial Sector
Module 22: Saving, Investment, and the Financial System
Lecture Notes
The purpose of this module is to introduce the financial system and the key roles that saving and
investment play. This module also begins to prepare students to learn about the Federal Reserve
and monetary policy in future modules.
Student learning objectives:
• The relationship between savings and investment spending.
• The purpose of the five principal types of financial assets: stocks, bonds, loans, real estate, and
bank deposits.
• How financial intermediaries help investors achieve diversification.
Key Economic Concepts For This Module:
• The savings investment identity tells us that, in a simple economy without government or
foreign trade, that private dollars saved must equal private dollars invested.
• When the government is included, we discover that the government can also contribute to
national savings if there is a budget surplus, and can detract from national savings if there is a
budget deficit.
• Money can also flow into the U.S. from foreign citizens and money can flow from the U.S.
into foreign economies. This inflow or outflow affects domestic saving and investment.
• If foreign citizens save more money in the U.S., than Americans save in other nations, there
exists a positive capital inflow of money into the U.S. This increases domestic investment.
• If Americans save more in other nations, than foreign citizens save in the U.S., there exists a
negative capital inflow of money in the U.S. This decreases domestic investment.
• The financial system facilitates transactions between savers and investors and provides three
key roles in the process: reducing transaction costs, reducing risk, and increasing liquidity.
I. Matching Up Savings and Investment Spending
When a firm invests in physical _______________ (factories, shopping malls, large pieces of
machinery, etc), the firm usually pays for these big projects by ___________________. Those
funds have to come from somewhere.
This module will discuss the source of those funds and the entities that help to provide access to
the funds.
A. The Savings– Investment Spending Identity
(Note: ____________ equals _________________. S=I)
This is known as the savings–investment spending identity.
We start with the simplest of economies, but it still holds when we bring in the public and
foreign sectors.
_______________ economy: no government, no trade (zero imports and exports).
Remember the very simple circular flow diagram. All money spent by consumers and
firms ends up in another person’s pocket as income (including profit).
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Total ______________ = Total ___________ = C + I
Now, what do people do with income? They either spend it on consumption (C) or save it
(S).
Total income = C + S = Total Spending = C + I
_______________________ Or ______________
What if the economy isn’t so simple?
 Add the government (public sector) to the private sector.
The government spends on goods and services (G) and pays transfers to some. The
government collects ________ ______________ to pay for these things.
If the government budget is balanced: (What a concept!)
________ ______________ = government spending + transfer payments
Rearrange this equation and call it _______________ ______________ (BB)
Budget Balance = Tax Revenue – G – transfers

If BB >0, the government has a budget _____________ and is actually
_________________ money.

If BB<0, the government has a budget _________ and is
___________________ money (dissaving).
We can now include public sector savings to the savings-investment identity.
S + BB: simply total national savings.
S + BB = I
• If BB>0 on the left side (a _________), I must _________ on the right side.
• If BB<0 on the left side (a _________), I must _________ on the right side.
Final level of complexity.
Add the foreign sector.
An American can save her money in the U.S. or in another nation.
A foreign citizen can save his money in his home country, or in the U.S.
So, the U.S. receives _________ of funds—foreign savings that finance investment
spending in the US.
The U.S. also generates _________ of funds—domestic savings that finance investment
spending in another country.
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Let’s define:
________________ _________into the U.S. = total inflow of foreign funds - total
outflow of domestic funds to other countries.
Capital inflow (CI) can be _________ or _________ so it can increase or decrease the
total funds available for investment in the U.S. economy.
S + BB + CI = I
• If CI > 0 on the left side (more foreign funds coming into the U.S., than U.S.
funds going out), I must _____________ on the right side.
• If CI < 0 on the left side (fewer foreign funds coming into the U.S., than U.S.
funds going out), I must _____________ on the right side.
II. The Financial System
Financial markets are where households invest their current savings and their accumulated
savings, or _________, by purchasing financial assets.
A ______________ _________is a paper claim that entitles the buyer to future income from the
seller.
There are four types of financial assets.
Before we get into those specific assets, we look at the role the financial system plays in
exchanging the assets from the seller to the buyer.
A. Three Tasks of a Financial System
1. Reducing ____________________ Costs
Suppose a consumer wanted to buy a loaf of bread, a pound of apples, and a dozen
eggs. One way to do this is to drive to the bakery, then drive to the orchard, and then
drive to the farm. It is surely more convenient, and less costly, to buy from a firm that
specializes in providing these items: the supermarket.
Suppose a firm wanted to borrow some money to build a factory. One way to borrow
would be to go to Mr. Jones for a loan, Ms. Sanchez for another loan, the Johnson
family for another… Or the firm could find a firm that specializes in providing these
funds: a bank.
The bank, and other financial services companies, is able to make it easier, and less
costly, for firms to engage in financial transactions like borrowing to make
investments.
2. Reducing _________
The future is uncertain so investments, like building a factory, have a risk that they
will not be profitable.
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The owner of a firm may want to build the factory, but using his/her own money is
risky because the factory might not be profitable. The owner could raise the money by
selling shares of stock in the company. When a person buys a share of stock in a
company, it gives that person a small stake in the ownership of the company. The
primary owner of the business can pay for the factory, but does not need to risk his/her
own money if the factory should fail to generate profits.
__________________________: investing in several assets with unrelated, or
independent, risks—allows a business owner to lower his/her total risk of loss.
The desire of individuals to reduce their total risk by engaging in diversification is
why we have stocks and a stock market.
3. Providing ___________________
Liquidity refers to the ease by which an asset can be converted to cash.
A vintage Rolls Royce is a valuable asset, but isn’t very liquid.
A savings account is very liquid.
If a firm needs money to build a factory, that investment in a physical asset will not
provide a stream of cash revenue for a long time. Until the factory begins to produce
goods that generate revenue, the firm may need liquidity (cash) to purchase raw
materials, hire some workers and pay the electric bill. The financial system can
provide liquidity in a variety of ways: by issuing loans, bonds, or stocks.
B. Types of Financial Assets
1. _________
A loan is a lending agreement between an individual lender and an individual
borrower.
2. _________
The seller of a bond promises to pay a fixed sum of interest each year and to repay the
principal—the value stated on the face of the bond—to the owner of the bond on a
particular date.
3. Loan-backed ___________________
Loan-backed securities are assets created by pooling individual loans and selling
shares in that pool (a process called securitization).
4. _________
A stock is a share in the ownership of a company.
C. Financial Intermediaries
A _______________ _______________is an institution that transforms funds gathered
from many individuals into financial assets. The most important types of financial
intermediaries are mutual funds, pension funds, life insurance companies, and banks.
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1. _________ Funds
A mutual fund is a financial intermediary that creates a stock portfolio by buying and
holding shares in companies and then selling shares of the stock portfolio to individual
investors.
2. _______________ Funds and _________ _______________Companies
Pension funds are nonprofit institutions that collect the savings of their members and
invest those funds in a wide variety of assets, providing their members with income
when they retire.
Life insurance companies sell policies which guarantee a payment to the
policyholder’s beneficiaries (typically, the family) when the policyholder dies.
3. _________
A bank is a financial intermediary that provides liquid financial assets in the form of
deposits to lenders and uses their funds to finance the illiquid investment spending
needs of borrowers.
Common Student Difficulties:
• It is intuitive for students to understand that they have two choices with their income: consume
it or spend it. However, students can find it difficult to understand that the government and
foreign sectors also have those options.
• The use of a simple hypothetical example of government saving (or dissaving) and positive (or
negative) capital inflow can illustrate how this affects domestic investment.
• Eyes can glaze over when discussion turns to financial assets and financial intermediaries. It
might be helpful to give the students a mini-research assignment to look up one of the assets or
intermediaries and present to the group what it (or they) does. A guest speaker from a bank,
insurance company, or investment firm could also energize the discussion.
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