Topic 4
Saving, Investment, and the financial system
 Savings are necessary for capital accumulation
*** Savings = Investment
 Connecting savers and borrowers increases the gains from trade and
smoothens economic growth
Demand and Supply:
 Law of Demand
o Demand is based on the willingness to pay
o Marginal benefit is decreasing in quantity demanded
 Holding other factors equal, quantity demanded of a
good falls when the price of that good rises
 Law of Supply
o Diminishing marginal returns
o Marginal cost rises with quantity supplied
o Require more costs to produce the same unit of output
 Holding other factors equal, quantity supplied of a
good rises when the price of that good rises
 Equilibrium
o When the price and quantity intersects
o Over-supply: quantity supplied exceeds quantity demanded
 There is a surplus so they need to cut prices
o Over-demand: quantity demanded exceeds quantity supplied
 There is a shortage so they need to raise prices
Supply of Savings
 Smoothing Consumption
o Avoid sudden changes of consumption
o Saving for retirement
o Save when you have surplus and use that when you don’t have
income
o Saving builds a cushion for unemployment and unexpected
problems
 Interest Rate of Saving
o Higher the interest rate, the greater the quantity saved
o Interest rate is the opportunity cost of consumption
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 The Demand to Borrow
o Businesses borrow
o Households borrow
o Individuals borrow
Equilibrium in Loanable Funds
 Market for loanable funds: occurs when suppliers of loanable funds
(savers) trade with demanders of loanable funds (borrowers). Trading
in the market for loanable funds determines the equilibrium interest
rate
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Role of Intermediaries
 Financial Intermediaries reduce the costs of moving savings from
savers to borrowers and help mobilize savings toward productive uses
 Equilibrium does not come automatically
 Savers move their capital to find the highest returns
 Financial Intermediaries – banks, bond markets, and stock markets
reduce the costs of moving savings from savers to borrowers and
investors
 Banks
o Receive savings from individuals and pay them interest
o Loan out funds to borrowers and charge them interest
o Banks earn profit by charging more for their loans than they pay
for the savings
o Specializing in loan evaluation
Bond Market
 Bond issuers are borrowers. They are DEMANDING money resources
 Bond market is an alternative for savers to SUPPLY their money to the
system
 Investors (mean savers) can more easily find information about large,
well-known corporations
o More willing to bypass banks and lend to companies directly
 A corporation acknowledges its debt to a member of the public by
issuing a bond
o Bond Contract lists how much is owed, the rate of interest, and
when the payment is due
o Bonds are a way to raise a large sum of money for long-lived
assets, and you pay it back over a long period of time
o ALL BONDS involve default risk
 The risk that the borrower will not pay the loan back
o Interest Rates differ depending on the borrower
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 Collateral – Something of value that by agreement becomes the
property of the lender if the borrower defaults
 U.S Government Bonds
o Government sometimes wants to finance public projects by
issuing bonds
Crowding out: The decrease in private consumption and investment that
occurs when government borrows more
Bond Price and Interest Rate
 When a member of the public lends money to a corporation, the
corporation acknowledges its debt by issuing a bond
 The bond contract lists how much is owed to the bond owners and
when the payment will be made
 Relationship between bond price and interest rate; we use ZeroCoupon Bonds
o No periodic payments
o All money will be returned on the day of maturity
 The value of a bond maturity is called the Face Value (FV)
 The Rate of Return, implied interest rate,
o Rate of return = (FV – Price) / (Price) x 100
 Sellers of bonds must compete to attract leaders
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When the bond becomes less attractive, demand decreases
Price also drops in a demand-supply
Interest rates and bond prices move in opposite directions
When bond prices fall, interest rates go up; when bond prices rise,
interest rates drop.