Pump Primer
• List the four types of
financial assets.
Module 22
Saving,
Investment, and
the Financial System
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The relationship between savings and
investment spending
• The purpose of the four principal types of
financial assets: stocks, bonds, loans and
bank deposits
• How financial intermediaries help
investors achieve diversification
Biblical Integration
• The parable of the talents is a good
passage indicating the priority of putting
to good use the resources that God has
entrusted to us. (Matt 25:14-30)
• Stewardship requires that we balance the
marginal benefit of an investment
strategy against the marginal cost (risk of
loss) and make our decisions
accordingly.
Matching up Savings and
Investment Spending
• When a firm invests in
physical capital (factories,
shopping malls, large pieces
of machinery, etc), the firm
usually pays for these big
projects by borrowing.
Those funds have to come
from somewhere.
Matching up Savings and
Investment Spending
• A. The Savings– Investment Spending
Identity
• (Note: Savings equals Investment. S=I)
• This is known as the savings–
investment spending identity.
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.
Simple 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).
Total income = Total spending = C + I
The Savings-Investment Spending Identity
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
C+S=C+I
Or
S=I
The Savings-Investment Spending Identity
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 tax revenue to pay for these things.
The Savings-Investment Spending Identity
If the government budget is balanced: (What a
concept!)
Tax revenue = government spending + transfer
payments
Rearrange this equation and call it Budget
Balance (BB)
The Savings-Investment Spending Identity
Budget Balance = Tax Revenue – G – transfers
If BB >0, the government has a budget surplus
and is actually saving money.
If BB<0, the government has a budget deficit and
is borrowing money (dissaving).
The Savings-Investment Spending Identity
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 surplus), I must
increase on the right side.
• If BB<0 on the left side (a deficit), I must
decrease on the right side.
The Savings-Investment Spending Identity
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.
The Savings-Investment Spending Identity
So, the U.S. receives inflows of funds—foreign
savings that finance investment spending in the
US.
The U.S. also generates outflows of funds—
domestic savings that finance investment
spending in another country.
The Savings-Investment Spending Identity
Let’s define:
Capital inflow into the U.S. = total inflow of foreign
funds - total outflow of domestic funds to other
countries.
Capital inflow (CI) can be positive or negative so it
can increase or decrease the total funds available
for investment in the U.S. economy.
The Savings-Investment Spending Identity
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 increase 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 decrease on the right side.
The Financial System
• Financial markets are where households invest their
current savings and their accumulated savings, or wealth,
by purchasing financial assets.
• A financial asset 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.
Three Tasks of a Financial System
1. Reducing Transaction 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.
Three Tasks of a Financial System
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.
Three Tasks of a Financial System
2. Reducing Risk
The future is uncertain so investments, like building a
factory, have a risk that they will not be profitable.
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.
Three Tasks of a Financial System
Diversification: 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.
Three Tasks of a Financial System
3. Providing Liquidity
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.
Types of Financial Assets
1. Loans - A loan is a lending agreement between an individual
lender and an individual borrower.
2. Bonds - 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 Securities - Loan-backed securities are
assets created by pooling individual loans and selling shares
in that pool (a process called securitization).
4. Stocks - A stock is a share in the ownership of a company.
Financial Intermediaries
A financial intermediary 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.
Financial Intermediaries
1. Mutual 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. Pension Funds and Life Insurance 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.
Financial Intermediaries
3. Banks
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.