chapter:
10
>> Savings, Investment
Spending, and the
Financial System
Krugman/Wells
©2009  Worth Publishers
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Matching Up Savings and Investment Spending



The budget balance is the difference between tax
revenue and government spending.
National savings, the sum of private savings plus
the budget balance, is the total amount of savings
generated within the economy.
Capital inflow is the net inflow of funds into a
country.
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The Savings–Investment Spending Identity

In a simplified economy:



Meanwhile, spending consists of either
consumption spending or investment spending:


(3) Total spending = Consumption spending +
Investment spending
Putting these together, we get:


(1) Total Income = Total Spending
(2) Total income = Consumption spending + Savings
(4) Consumption spending + Savings = Consumption
spending + Investment spending
Subtract consumption spending from both sides,
and we get:

(5) Savings = Investment spending ……Money Saved by
Households is loaned out by Banks in the Loanable
Funds Market
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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.
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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.
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The Demand for Loanable Funds
Real
interest
rate
12%
A
B
4
Demand for loanable funds, D
0
$150
450
Quantity of loanable funds
(billions of dollars)
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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)
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Equilibrium in the Loanable Funds Market
Interest
rate
Projects with rate of
return
8% or greater are
funded.
12%
Offers not accepted from
lenders who demand interest
rate of more than 8%.
r*
8
Projects with rate of return
less than 8% are not
funded.
4
Offers accepted from
lenders willing to lend at
interest rate of 8% or less.
0
$300
Q*
Quantity of loanable
funds
(billions of dollars)
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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.
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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
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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: Money invested in US
banks by Foreign countries/businesses. This money is
immediately converted into an increase in the supply of
loanable funds. More capital inflows = positive shift in
Supply of loanable funds.
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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
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Inflation and Interest Rates


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.
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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.
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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.
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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
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►ECONOMICS IN ACTION
Changes in the U.S. Interest Rates Over Time
(a) Changes in Expected
Inflation and Interest
Rates
(b) Changes in Expected Rate of Return
on Investment Spending and Interest
Rates
10-Year
Treasury
constant
maturity rate,
inflation rate
10-Year
Treasury
constant
maturity rate
7%
16%
14
6
12
10
5
8
4
6
4
3
2
1958
2008
1970
1980
1990
2000
Year
1998
2008
2000
2002
2004
2006
Year
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The Financial System

A household’s wealth is the value of its
accumulated savings.

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.
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The Financial System

A liability is a requirement to pay income in the
future.

Transaction costs are the expenses of negotiating
and executing a deal.

Financial risk is uncertainty about future outcomes
that involve financial losses and gains.
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The Financial System
(a) Typical Individual
Change in
individual
welfare
Wealth gain from
gaining $1,000
(b) Wealthy Individual
Change in
individual
welfare
$1,000
$1,000
0
0
–2,000
Wealth loss from
losing $1,000
Wealth gain from
gaining $1,000
–1,200
Wealth loss from
losing $1,000
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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.

Providing liquid assets ─ assets that can be
quickly converted into cash (in contrast to illiquid
assets, which can’t).
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Three Tasks of a Financial System

An individual can engage in diversification by
investing in several different things so that the
possible losses are independent events.

An asset is liquid if it can be quickly converted into
cash.

An asset is illiquid if it cannot be quickly converted
into cash.
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Types of Financial Assets

There are four main types of financial assets:





loans
bonds
stocks
bank deposits
In addition, financial innovation has allowed the
creation of a wide range of loan-backed
securities.
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Types of Financial Assets



A loan is a lending agreement between a particular
lender and a particular borrower.
A default occurs when a borrower fails to make
payments as specified by the loan or bond contract.
A loan-backed security is an asset created by
pooling individual loans and selling shares in that
pool.
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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.
A pension fund is a type of mutual fund that holds
assets in order to provide retirement income to its
members.
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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.
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An Example of a Diversified Mutual Fund
Fidelity Spartan S&P 500 Index Fund,
Top Holdings (as of September 2008)
Company
Exxon Mobil
Percent of mutual fund assets
invested in a company
3.96%
General Electric
2.49
Procter & Gamble
2.08
Microsoft
2.06
Johnson & Johnson
1.90
JPMorgan Chase
1.69
Chevron
1.66
AT&T
1.62
Bank of America
1.57
IBM
1.56
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►ECONOMICS IN ACTION
Banks and the South Korean Miracle


In the early 1960s, South Korea’s interest rates on deposits
were very low at a time when the country was experiencing
high inflation. So savers didn’t want to save by putting
money in a bank, fearing that much of their purchasing
power would be eroded by rising prices. Instead, they
engaged in current consumption by spending their money
on goods and services or on physical assets such as real
estate and gold.
In 1965 the South Korean government reformed the
country’s banks and increased interest rates. Over the next
five years the value of bank deposits increased 600% and
the national savings rate more than doubled. The
rejuvenated banking system made it possible for South
Korean businesses to launch a great investment boom, a
key element in the country’s growth surge.
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Financial Fluctuations


Financial market fluctuations can be a source of
macroeconomic instability.
Stock prices are determined by supply and demand
as well as the desirability of competing assets, like
bonds:

when the interest rate rises, stock prices generally fall
and vice versa.
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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.
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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.
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FOR INQUIRING MINDS
How Now, Dow Jones?



Financial news reports often lead with the day’s stock
market action, as measured by changes in the Dow Jones
Industrial Average, the S&P 500, and the NASDAQ. All
three are stock market indices. Like the consumer price
index, they are numbers constructed as a summary of
average prices.
The Dow, created by the financial analysis company Dow
Jones, is an index of the prices of stock in 30 leading
companies, The S&P 500 is an index of 500 companies,
created by Standard and Poor’s. The NASDAQ is compiled
by the National Association of Securities Dealers.
The movement in an index gives investors a quick, snapshot
view of how stocks from certain sectors of the economy are
doing.
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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.
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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.
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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.
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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?
This debate covered in chapter 17.
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►ECONOMICS IN ACTION
The Great American Housing Bubble




Between 2000 and 2006, there was a huge increase in the
price of houses in America. A number of economists argued
that this price increase was excessive—that it was a
“bubble”.
Yet there were also a number of economists who argued
that the rise in housing prices was completely justified.
They pointed, in particular, to the fact that interest rates
were unusually low in the years of rapid price increases.
They argued that low interest rates combined with other
factors, such as growing population, explained the surge in
prices.
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►ECONOMICS IN ACTION
The Great American Housing Bubble




Alan Greenspan, the chairman of the Federal Reserve,
conceded in 2005 that there might be some “froth” in the
markets but denied that there was any national bubble.
Unfortunately, it turned out that the skeptics were right.
Greenspan himself would later concede that there had, in
fact, been a huge national bubble.
In 2006, as home prices began to level off, it became
apparent that many buyers had held unrealistic expectations
about future prices.
Home prices began falling, and the demand for housing fell
drastically.
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►ECONOMICS IN ACTION
The Great American Housing Bubble
New
single-family
houses sold
(thousands)
Index
(2000 = 100)
220
200
1,400
180
1,200
160
140
1,000
120
800
100
600
80
2000
2008
2002
2004
2006
Year
2000
2008
2002
2004
2006
Year
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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.
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.
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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. 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.
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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.
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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).
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SUMMARY
6. Although many small and moderate-size 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. Most people are risk-averse. Loanbacked 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.
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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 of long-run economic growth.
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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, like bonds: when the interest rate rises,
prices of stocks and physical assets such as real estate
generally fall, and vice versa. 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.
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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.
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The End of Chapter 10
coming attraction:
Chapter 11:
Income and Expenditure
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