Chapter 10: Savings, Investment, Spending and the Financial System
Savings-Investment Spending Identity
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Recall that Y = C + I + G + NX
Now suppose that we are in a closed economy (i.e. NX=0)
Thus, we have Y = C + I + G (1)
We can also think of Savings as S = Y – C – G (2)
If we substitute our definition of Y from (1) into (2), we are thus left with the following:
S = Y – C – G = I + (C +G) – (C +G) =I
Further, we can split savings into two components:
o SPrivate = Y – C – (T – TR)
o SPublic = T – G – TR
o STotal = SPrivate + SPublic
Market for Loanable Funds
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Suppliers in this market are households saving money for future consumption
Demand comes from firms looking to make investments
The “price” in this market is the real interest rate
o The “law of demand” and “law of supply” apply here: as the real interest rate rises
firms are less likely to borrow money and households are more likely to save money
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Shifts in Demand include: Perceived changes in business opportunities and changes in
government spending
Shifts in Supply include: Changes in private behavior and in net capital flows
Crowding Out: An increase in the Government deficit will reduce Investment spending
The Fisher Effect: Changes in expected inflation increase the nominal interest rate (it has no
impact on the equilibrium quantity in the loanable funds market)
The Financial System
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Financial Markets are where households invest their wealth to buy financial assets
Financial Assets is a paper claim that that entitles the buyer to future income from the seller
Households can also purchase physical assets, tangible objects used to generate future
income (ex. a house)
If a household takes out a loan, the household and the bank also create a liability, an
obligation to pay income in the future
There are three functions of the financial system:
o Reducing Transaction Costs: reducing the cost of actually putting together and
executing a deal
o Reducing Risk: primarily done through diversification, investing in several assets
with unrelated risks
o Providing Liquidity: providing currency to those in need of it
Types of Financial Assets
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Loans are lending agreements between a lender and a borrower
Bonds are an IOU between the borrow and lender where the borrower pays a fixed amount
over time plus the principle at the end of the specified timeframe
Loan-Backed Securities are assets made by pooling individual loans and selling shares in
that pool
Stocks are shares in the ownership of a company
Financial Intermediaries
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A financial intermediary is an institution that transforms funds from many individuals into
financial assets
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
Pension Funds are nonprofit institutions that collect the savings of their customers and
invest the funds in a variety of assets, providing them with income when they retire
Life Insurance Companies are companies that guarantee a payment to the policyholder’s
beneficiaries when the policyholder dies
Banks collect deposits from individuals and use those deposits to provide investment funds
to borrowers
Questions
Exercise 1: Calculate (a) through (d) using the following information:
Y = $100, C = $55, T = $20, G = $13, Transfers = $1
a) Private Savings
b) Public Savings
c) Domestic Savings
d) Domestic Investment
Exercise 2: There is a government budget deficit if
A) T – Transfers > G.
B) G < T.
C) G < TR.
D) Transfers + G > T
Exercise 3: If technological change increases the profitability of new investment for firms, then
the ______ curve for loanable funds will shift to the ______ and the equilibrium real interest rate
will ______.
A) demand; right; rise
B) supply; left; rise
C) supply; right; fall
D) demand; left; fall
Exercise 4: Which of the following is not a type of financial asset?
a) Loans
b) Pension Funds
c) Bonds
d) Stocks
Exercise 5: In a closed economy,
a) Y = C + G + NX
b) Y = C + I + S
c) Y = C + I + T
d) Y = C + I + G
Exercise 6: Which of the following statements are true?
a) In an open economy, the only source of funds for investment spending is domestic savings
b) In a closed economy, the only use of savings is to provide funds to finance government deficits
c) In a closed economy, the only source of funds for investment spending is domestic savings
d) Answers (a) and (b) are both true
e) Answers (b) and (c) are both true
Exercise 7: Which of the following statements is true?
a) I = GDP – C – G in a closed economy
b) GDP = C + I + G + X – IM in an open economy
c) GDP = Sprivate + T + C –TR
d) Spublic = T – TR – G
e) All of the above
Exercise 8: When the government runs a deficit, this shifts the
a) Supply of loanable funds curve to the right
b) Supply of loanable funds curve to the left
c) Demand for loanable funds curve to the right
d) Demand for loanable funds curve to the left
Exercise 9: Financial markets provide a means for
a) Reducing risk for borrowers and lenders
b) Reducing transaction costs for borrowers and lenders
c) Enhancing liquidity for borrowers and lenders
d) All of the above
Exercise 10: Suppose Joe lends Maxine $100 for the year. At the end of the year, Maxine repays Joe the
$100 plus an additional $15 for the use of Joe’s money during the year. Assuming no inflation, the
interest rate Maxine pays is:
a) .15%
b) 1.5%
c) 15%
d) 115%