THIRD EDITION
ECONOMICS
and
MACROECONOMICS
Chapter 10
Savings, Investment Spending, and the Financial System
WHAT YOU
WILL LEARN
IN THIS
CHAPTER
• The relationship between savings and
investment spending
• Aspects of the loanable funds market,
which shows how savers are matched
with borrowers
• The purpose of the five principal types
of assets: stocks, bonds, loans, real
estate, and bank deposits
• How financial intermediaries help
investors achieve diversification
• Some competing views of what
determines stock prices and why stock
market fluctuations can be a source of
macroeconomic instability
Funds for Facebook
How Investment Spending is Financed ?
• According to the savings–investment spending identity,
savings and investment spending are always equal for the
economy as a whole.
• Savings-Investment Identity in a Closed Economy
\
How Investment is Financed?
• Savings – Investment Identity in an Open Economy
Matching Up Savings and Investment Spending
• The ________________ is the difference between tax
revenue and government spending when tax revenue
exceeds government spending.
• The ________________ is the difference between tax
revenue and government spending when government
spending exceeds tax revenue.
• The ________________ is the difference between tax
revenue and government spending.
• _______________ , the sum of private savings plus the
budget balance, is the total amount of savings generated
within the economy.
• The ______________ is the net inflow of funds into a
country.
The Savings–Investment Spending Identity
(a) United States, 2007
(b) Japan, 2007
Share
of GDP
25%
20
15
10
5
0
–5
–10 Investment
–15 spending
Share
of GDP
Capital
inflows
Budget
deficit
Private
savings
Savings
25%
20
15
10
5
0
–5
Capital
–10 Investment
outflows
–15 spending
Budget
deficit
Private
savings
Savings
The Market for Loanable Funds
• The loanable funds market is a hypothetical market that
examines the market outcome of the demand for funds
generated by borrowers and the supply of funds provided by
lenders.
•
• The interest rate is the price, calculated as a percentage of
the amount borrowed, charged by the lender to a borrower
for the use of their savings for one year.
The Market for Loanable Funds
The rate of return on a project is the profit earned on the
project expressed as a percentage of its cost.
The Demand for Loanable Funds
Interest
rate
12%
A
B
4
Demand for loanable funds, D
0
$150
450
Quantity of loanable funds
(billions of dollars)
The Supply for Loanable Funds
Interest
rate
Supply of loanable funds, S
12%
4
0
Y
X
$150
450
Quantity of loanable funds
(billions of dollars)
Equilibrium in the Loanable Funds Market
Interest
rate
12%
r*
8
4
0
$300
Q*
Quantity of loanable funds
(billions of dollars)
Shifts of the Demand for Loanable Funds
• Factors that can cause the demand curve for loanable funds
to shift include:
 Changes in perceived business opportunities.
 Changes in the government’s borrowing.
• Crowding out occurs when a government deficit drives up
the interest rate and leads to reduced investment spending.
An Increase in the Demand for Loanable Funds
Interest
rate
S
. . . leads to a
rise in the
equilibrium
interest rate.
r
r
An increase in the
demand for
loanable funds . . .
2
1
D
D
2
1
Quantity of loanable funds
Shifts of the Supply for Loanable Funds
•
Factors that can cause the supply of loanable funds to
shift include:

Changes in private savings behavior: Between 2000 and
2006 rising home prices in the United States made many
homeowners feel richer, making them willing to spend more
and save less.


This shifted the supply of loanable funds to the left.
Changes in capital inflows: The United States has received
large capital inflows in recent years, with much of the
money coming from China and the Middle East.

Those inflows helped fuel a big increase in residential
investment spending from 2003 to 2006. As a result of the
worldwide slump, those inflows began to trail off in 2008.
An Increase in the Supply of Loanable Funds
Interest
rate
S
1
S
. . . leads to a fall
in the equilibrium
interest rate.
r
r
2
1
An increase in the
supply for loanable
funds . . .
2
D
Quantity of loanable funds
Inflation and Interest Rates
• Anything that shifts either the supply of loanable funds
curve or the demand for loanable funds curve changes the
interest rate.
• Historically, major changes in interest rates have been
driven by many factors, including:
 Changes in government policy.
 Technological innovations that created new investment
opportunities.
 Changes in Expected Inflation.
Inflation and Interest Rates
• However, arguably the most important factor affecting
interest rates over time is changing expectations about
future inflation.
• This shifts both the supply and the demand for loanable
funds.
• This is the reason, for example, that interest rates today are
much lower than they were in the late 1970s and early
1980s.
Inflation and Interest Rates
• Real interest rate = Nominal interest rate − Inflation rate
• In the real world neither borrowers nor lenders know what
the future inflation rate will be when they make a deal.
Actual loan contracts, therefore, specify a nominal interest
rate rather than a real interest rate.
The Fisher Effect
• According to the Fisher effect, an increase in expected
future inflation drives up the nominal interest rate, leaving
the expected real interest rate unchanged.
The Fisher Effect
Nominal
Interest rate
Demand for loanable funds
at 10% expected inflation
Supply of loanable
funds
at 10% expected
inflation
S
10
E
10
14%
Demand for loanable
funds
at 0% expected inflation
4
Supply of loanable
funds at 0%
expected inflation
D
10
S
0
E
0
D
0
Q*
0
Quantity of loanable
funds
The Fisher Effect
Example 1 :
Suppose that the expected inflation rises from 3% - 6%. Assume the
real interest rate is 4%. If the system follows the fisher’s effect, then
answer the followings.
a. What happens to the expected real interest rate?
b. What happens to the Nominal interest rate?
c. What will happen to the equilibrium loanable funds?
The Fisher Effect
Now try this out :
Use a demand and supply diagram to explain the changes to
equilibrium values in a loanable funds market when there is a 2%
fall in the expected future inflation.
Note : Assume the equilibrium interest rate at the beginning is
8%.
The Financial System
• What is a financial Market?
Financial Market is where households invest their current savings
and their accumulated savings (wealth) by purchasing financial
assets.
*** In a financial market lenders and Borrows meet each other to
exchange their needs.
• A household’s wealth is the value of its accumulated savings.
*** Difference Between Income and Wealth ????
• A financial asset is a paper claim that entitles the buyer to
future income from the seller.
• A physical asset is a claim on a tangible object that gives the
owner the right to dispose of the object as he or she wishes.
The Financial System
 A liability is a requirement to pay income in the future.
Example : Mary take a mortgage from Chase Bank.
 For Bank >
 For Mary >
 Transaction costs are the expenses of negotiating and
executing a deal.
 Legal Fees
 Paper Work Fees
 Financial risk is uncertainty about future outcomes that
involve financial losses and gains.
Three Tasks of a Financial System
•
Reducing transaction costs ─ the cost of making a deal.
•
Reducing financial risk ─ uncertainty about future
outcomes that involves financial gains and losses. (Try for a
diverse financial asset portfolio)
•
Providing liquid assets ─ assets that can be quickly
converted into cash (in contrast to illiquid assets, which
can’t) ;
 An asset is liquid if it can be quickly converted into
cash. (e.g. Treasury Bonds, Travelers Checks etc …)
 An asset is illiquid if it cannot be quickly converted
into cash. ( Houses, Corporate Bonds)
Types of Financial Assets
 There are four main types of financial assets:
1)
2)
3)
4)
loans
bonds
stocks
bank deposits
 In addition, financial innovation has allowed the creation of
a wide range of loan-backed securities.
Types of Financial Assets
• A loan is a lending agreement between a particular lender
and a particular borrower.
• A bond is an IOU issued by the borrower.
• A Stock is a share of the ownership of a company.
• A bank deposit is what you save in the banks (checking /
savings/ fixed deposits etc …).
• A loan-backed security is an asset created by pooling
individual loans and selling shares in that pool.
• Default >>>>
• A default occurs when a borrower fails to make
payments as specified by the loan or bond
contract.
BONDS
Financial Intermediaries
• A financial intermediary is an institution that transforms the
funds it gathers from many individuals into financial assets.
• A mutual fund is a financial intermediary that creates a
stock portfolio and then resells shares of this portfolio to
individual investors.
Examples:
http://www.youtube.com/watch?v=fpcvJiO-rjk
• A pension fund is a type of mutual fund that holds assets in
order to provide retirement income to its members.
Examples:
Financial Intermediaries
• A life insurance company sells policies that guarantee a
payment to a policyholder’s beneficiaries when the
policyholder dies.
• A bank deposit is a claim on a bank that obliges the bank to
give the depositor his or her cash when demanded.
• A bank is a financial intermediary that provides liquid assets
in the form of bank deposits to lenders and uses those
funds to finance the illiquid investments or investment
spending needs of borrowers.
An Example of a Diversified Mutual Fund
Financial Fluctuations
READING Assignment
Pages 298 – 303
Quiz 6 – Write a one page summary on “Financial
Fluctuations”
• Financial market fluctuations can be a source of
macroeconomic instability.
• Stock prices are determined by supply and demand, as well
as by the desirability of competing assets, like bonds:
 when the interest rate rises, stock prices generally fall and vice
versa
Financial Fluctuations
• The value of a financial asset today depends on investors’
beliefs about the future value or price of the asset.
• If investors believe that it will be worth more in the future,
they will demand more of the asset today at any given
price.
• Consequently, today’s equilibrium price of the asset will
rise.
Financial Fluctuations
• If investors believe the asset will be worth less in the future,
they will demand less today at any given price.
• Consequently, today’s equilibrium price of the asset will fall.
• Today’s stock prices will change according to changes in
investors’ expectations about future stock prices.
Financial Fluctuations
• Financial market fluctuations can be a source of
macroeconomic instability.
• There are two principal competing views about how asset
price expectations are determined.
• One view, which comes from traditional economic analysis,
emphasizes the rational reasons why expectations should
change.
• The other, widely held by market participants and also
supported by some economists, emphasizes the
irrationality of market participants.
Financial Fluctuations
• One view of how expectations are formed is the efficient
markets hypothesis, which holds that the prices of financial
assets embody all publicly available information.
• It implies that fluctuations are inherently unpredictable—
they follow a random walk.
Irrational Markets?
• Many market participants and economists believe that,
based on actual evidence, financial markets are not as
rational as the efficient markets hypothesis claims.
• Such evidence includes the fact that stock price fluctuations
are too great to be driven by fundamentals alone.
Asset Prices and Macroeconomics
• How do macroeconomists and policy makers deal with the
fact that asset prices fluctuate a lot and that these
fluctuations can have important economic effects?
• Should policy makers try to pop asset bubbles before they
get too big?
Summary
1. Investment in physical capital is necessary for long-run
economic growth. So, in order for an economy to grow, it
must channel savings into investment spending.
Summary
2. According to the savings–investment spending identity,
savings and investment spending are always equal for the
economy as a whole. The government is a source of
savings when it runs a positive budget balance or budget
surplus; it is a source of dissavings when it runs a negative
budget balance or budget deficit.
In a closed economy, savings is equal to national savings,
the sum of private savings plus the budget balance. In an
open economy, savings is equal to national savings plus
capital inflow of foreign savings. When a capital outflow,
or negative capital inflow, occurs, some portion of national
savings is funding investment spending in other countries.
Summary
3. The hypothetical loanable funds market shows how loans
from savers are allocated among borrowers with
investment spending projects.
In equilibrium, only those projects with a rate of return
greater than or equal to the equilibrium interest rate will
be funded.
By showing how gains from trade between lenders and
borrowers are maximized, the loanable funds market
shows why a well-functioning financial system leads to
greater long-run economic growth.
Summary
3. (Cont.) Government budget deficits can raise the interest
rate and can lead to crowding out of investment spending.
Changes in perceived business opportunities and in
government borrowing shift the demand curve for loanable
funds; changes in private savings and capital inflows shift
the supply curve.
Summary
4. Because neither borrowers nor lenders can know the
future inflation rate, loans specify a nominal interest rate
rather than a real interest rate.
For a given expected future inflation rate, shifts of the
demand and supply curves of loanable funds result in
changes in the underlying real interest rate, leading to
changes in the nominal interest rate.
According to the Fisher effect, an increase in expected
future inflation raises the nominal interest rate one-to-one
so that the expected real interest rate remains unchanged.
Summary
5. Households invest their current savings or wealth by
purchasing assets. Assets come in the form of either a
financial asset or a physical asset. A financial asset is also a
liability from the point of view of its seller.
There are four main types of financial assets: loans, bonds,
stocks, and bank deposits. Each of them serves a different
purpose in addressing the three fundamental tasks of a
financial system: reducing transaction costs—the cost of
making a deal; reducing financial risk—uncertainty about
future outcomes that involves financial gains and losses; and
providing liquid assets— assets that can be quickly
converted into cash without much loss of value (in contrast
to illiquid assets, which are not easily converted).
Summary
6. Although many small and moderately sized borrowers use
bank loans to fund investment spending, larger companies
typically issue bonds. Bonds with a higher risk of default
must typically pay a higher interest rate.
Business owners reduce their risk by selling stock. Although
stocks usually generate a higher return than bonds,
investors typically wish to reduce their risk by engaging in
diversification, owning a wide range of assets whose
returns are based on unrelated, or independent, events.
Summary
6. (Cont.) Loan-backed securities, a recent innovation, are
assets created by pooling individual loans and selling shares
of that pool to investors.
Because they are more diversified and more liquid than
individual loans, trading on financial markets like bonds,
they are preferred by investors. It can be difficult, however,
to assess their quality.
Summary
7. Financial intermediaries—institutions such as mutual
funds, pension funds, life insurance companies, and
banks—are critical components of the financial system.
Mutual funds and pension funds allow small investors to
diversify, and life insurance companies reduce risk.
8. A bank allows individuals to hold liquid bank deposits that
are then used to finance illiquid loans. Banks can perform
this mismatch because, on average, only a small fraction of
depositors withdraw their savings at any one time. Banks
are a key ingredient in long-run economic growth.
Summary
9. Asset market fluctuations can be a source of short-run
macroeconomic instability. Asset prices are determined by
supply and demand, as well as by the desirability of
competing assets such as bonds: when the interest rate
rises, prices of stocks and physical assets such as real estate
generally fall, and vice versa.
Summary
9. (Cont.) Expectations drive the supply of and demand for
assets: expectations of higher future prices push today’s
asset prices higher, and expectations of lower future prices
drive them lower.
One view of how expectations are formed is the efficient
markets hypothesis, which holds that the prices of assets
embody all publicly available information. It implies that
fluctuations are inherently unpredictable—they follow a
random walk.
Summary
10. Many market participants and economists believe that,
based on actual evidence, financial markets are not as
rational as the efficient markets hypothesis claims. Such
evidence includes the fact that stock price fluctuations are
too great to be driven by fundamentals alone.
Policy makers assume neither that markets always behave
rationally nor that they can outsmart them.