Chapter 7: Savings and Investment
Objectives
• Determinants of saving, investment, and interest rates
• Effect of government budget deficits on financial
markets, saving and investment
• Effect of international borrowing and lending on interest
rates, saving and investment.
Physical Capital vs. Financial Capital
 Physical capital
• Tools, instruments, machines, buildings, and other
items that have been produced in the past and that
are used today to produce goods and services.
 Financial capital
• The funds that firms use to buy physical capital.
Capital and Investment
 Gross investment
• total amount spent on purchases of new capital
and on replacing depreciated capital.
 Depreciation (capital consumption allowance)
• decrease in the quantity of capital that results from
wear and tear and obsolescence.
 Net investment
• change in the quantity of capital.
• gross investment  depreciation
Wealth and Saving
 Wealth
• the value of all the things that people own.
 Saving
• the amount of income that is not paid in taxes or
spent on consumption goods and services.
 Wealth increases with
• Saving
• Capital gains
 Wealth is decreased by capital losses.
 Wealth(t) = Wealth(t-1)+saving(t-1)+ capital gains(t-1)
Markets for financial capital
 Saving is the source of funds used to finance
investment.
 These funds are supplied and demanded in three
types of financial markets:
• Loan markets
• Bond markets
• Stock markets
Financial Institutions and markets
Financial institution
•a firm that that operates on both sides of the markets for financial
capital.
•borrower in one market and a lender in another.
Types of financial institutions
Investment banks
• Commercial banks
• Government-sponsored mortgage lenders
• Pension funds
• Insurance companies
•
The Market for Loanable Funds
The market for loanable funds is the aggregate of all the
individual financial markets.
Funds that Finance Investment
1. Household saving S
2. Government budget surplus (T –Tr – G)
3. Borrowing from the rest of the world (M – X)
Because Income Side of GDP = Expenditure Side of GDP
C + S + (T-Tr) = C + I + G + (X-M)
 I = S + (T-Tr) - G + (M-X)
The Market for Loanable Funds
 The market for loanable funds
• the market in which households, firms,
governments, and financial institutions borrow and
lend.
• The market influences
– Saving and investment
– Interest rates
The Market for Loanable Funds
 Nominal interest rate
• More specific name for “interest rate”
• Not adjusted for effects of inflation
• $ of interest / $ of loan
 Real interest rate
• nominal interest rate adjusted to remove the effects
of inflation on the purchasing power of money.
• nominal interest rate minus the inflation rate.
The Market for Loanable Funds
 Demand for loanable funds
• the relationship between the quantity of loanable
funds demanded and the real interest rate, ceteris
paribus.
• Business investment is the main item that makes
up the demand for loanable funds.
The Market for Loanable Funds
Changes in the Demand for Loanable Funds
(a shift in the demand curve)
 When expected profits rises (falls), the demand for
loanable funds rises (falls)
 Tax policy can affect demand for loanable funds
• Investment tax credit
• Accelerated depreciation.
The Market for Loanable Funds
The supply of loanable funds
• the relationship between the quantity of loanable
funds supplied and the real interest rate, ceteris
paribus.
• Saving is the main item that makes up the supply
of loanable funds.
The Market for Loanable Funds
The Market for Loanable Funds
 Changes in the supply of loanable funds
•
•
•
•
Temporary changes in disposable income
Expected future income
Wealth
Perceived default risk of borrowers
The Market for Loanable Funds: Equilibrium
The Market for Loanable Funds
• Assuming no government or international sector,
• SLF= Saving
• DLF=Investment
• What’s the effect of decline in future expected profits on
• Saving & Investment
• Real interest rate
Government in the Market for Loanable Funds
Government enters the loan market when it has a budget
surplus or deficit.
• A government budget surplus increases the supply of
funds
•
A government budget deficit increases the demand for
funds.
Government Surplus in the Market for Loanable Funds
Government Deficit in the Market for Loanable Funds
Government in the Market for Loanable Funds:
Ricardo-Barro Effect
The Global Loanable Funds Market
• The loanable funds market is global, not national.
• Financial capital is mobile: It moves to the best
advantage of lenders and borrowers.
• Because lenders are free to seek the highest real
interest rate and borrowers are free to seek the lowest
real interest rate, the loanable funds market is a single,
integrated, global market.
• Funds flow into the country in which the real interest rate
is highest and out of the country in which the real interest
rate is lowest.
The Global Loanable Funds Market
International Borrowing and Lending
 If a country’s net exports are negative,
• Country is a net borrower
• quantity of loanable funds in that country is greater
than national saving.
 If a country’s net exports are positive,
• the country is a net lender
• the quantity of loanable funds in that country is less
than national saving.
The Global Loanable Funds Market