N. Gregory Mankiw
Principles of
Macroeconomics
Sixth Edition
13
Saving, Investment,
and the Financial System
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Premium
PowerPoint
Slides by
Ron Cronovich
In this chapter,
look for the answers to these questions:
• What are the main types of financial institutions
in the U.S. economy, and what is their function?
• What are the three kinds of saving?
• What’s the difference between saving and
investment?
• How does the financial system coordinate saving
and investment?
• How do govt policies affect saving, investment,
and the interest rate?
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1
National Income Accounts
 Rules of national income accounting
 Important identities
 Identity
 An equation that must be true because of the
way the variables in the equation are defined
 Clarify how different variables are related to one
another
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22
Accounting Identities
 Gross domestic product (GDP)
 Total income
 Total expenditure
 Y = C + I + G + NX
• Y= gross domestic product GDP
• C = consumption
• G = government purchases
• NX = net exports
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33
Accounting Identities
 Closed economy
 Doesn’t interact with other economies
 NX = 0
 (of course, NX also equals 0 when exports
equal imports. But that’s not what we mean
here)
 Open economy
 Interact with other economies
 NX ≠ 0
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44
Accounting Identities
 Assumption: close economy: NX = 0
• Y=C+I+G
 National saving (saving), S
• Total income in the economy that remains after
paying for consumption and government
purchases
• Y–C–G=I
• S=Y–C-G
• S=I
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55
Accounting Identities
 T = taxes minus transfer payments
• S=Y–C–G
• S = (Y – T – C) + (T – G)
 Private saving, Y – T – C
 Income that households have left after paying
for taxes and consumption
 Public saving, T – G
 Tax revenue that the government has left after
paying for its spending
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66
Accounting Identities
 Budget surplus: T – G > 0
 Excess of tax revenue over government
spending
 Budget deficit: T – G < 0
 Shortfall of tax revenue from government
spending
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77
Saving and Investing
 Accounting identity: S = I
 Saving = Investment
 For the economy as a whole
 One person’s savings can finance another
person’s investment
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88
ACTIVE LEARNING
A. Calculations
1
 Suppose GDP equals $10 trillion,
consumption equals $6.5 trillion,
the government spends $2 trillion
and has a budget deficit of $300 billion.
 Find public saving, taxes, private saving,
national saving, and investment.
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ACTIVE LEARNING
Answers, part A
Given:
Y = 10.0,
1
C = 6.5,
G = 2.0,
G – T = 0.3
Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5
Investment = national saving = 1.5
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ACTIVE LEARNING
1
B. How a tax cut affects saving
 Use the numbers from the preceding exercise,
but suppose now that the government cuts taxes
by $200 billion.
 In each of the following two scenarios,
determine what happens to public saving,
private saving, national saving, and investment.
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend
the other 3/4.
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C l i c ke r q u e s t i o n !
Given:
Y = 10.0,
C = 6.5,
G = 2.0,
G – T = 0.3
If T is reduced by 0.2 and households save all of it,
what is the new level of public savings?
A. 0.1
B. 0.3
C. 0.5
D. 0.7
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A n o t h e r c l i c ke r q u e s t i o n !
Given:
Y = 10.0,
C = 6.5,
G = 2.0,
G – T = 0.3
If T is reduced by 0.2 and households save all of it,
what is the new level of private savings?
A. 1.6
B. 1.8
C. 2.0
D. 2.2
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Ye t a n o t h e r c l i c ke r q u e s t i o n !
Given:
Y = 10.0,
C = 6.5,
G = 2.0,
G – T = 0.3
If T is reduced by 0.2 and households save all of it,
what is the new level of national savings?
A. 1.3
B. 1.5
C. 1.7
D. 1.9
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Last clicker question for the moment!
Given:
Y = 10.0,
C = 6.5,
G = 2.0,
G – T = 0.3
If T is reduced by 0.2 and households save all of it,
what is happens to private investment?
A. It goes down by 0.2.
B. Nothing.
C. It goes up by 0.2.
D. All of the above.
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ACTIVE LEARNING
Answers, part B
1
In both scenarios, public saving falls by
$200 billion, and the budget deficit rises
from $300 billion to $500 billion.
1. If consumers save the full $200 billion,
national saving is unchanged,
so investment is unchanged.
2. If consumers save $50 billion and spend $150
billion, then national saving and investment
each fall by $150 billion.
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ACTIVE LEARNING
1
C. Discussion questions
The two scenarios from this exercise were:
1. Consumers save the full proceeds of the
tax cut.
2. Consumers save 1/4 of the tax cut and spend
the other 3/4.
 Which of these two scenarios do you think is
more realistic?
 Why is this question important?
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You are wurffless, Alec Baldwin!
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18
The Market for Loanable Funds
 A supply–demand model of the financial system
 Helps us understand
 how the financial system coordinates
saving & investment
 how govt policies and other factors affect
saving, investment, the interest rate
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19
The Market for Loanable Funds
Assume: only one financial market
 All savers deposit their saving in this market.
 All borrowers take out loans from this market.
 There is one interest rate, which is both the
return to saving and the cost of borrowing.
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20
The Market for Loanable Funds
The supply of loanable funds comes from saving:
 Households with extra income can loan it out
and earn interest.
 Public saving, if positive, adds to national
saving and the supply of loanable funds.
If negative, it reduces national saving and the
supply of loanable funds.
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21
The Slope of the Supply Curve
Interest
Rate
Supply
6%
3%
60
80
An increase in
the interest rate
makes saving
more attractive,
which increases
the quantity of
loanable funds
supplied.
Loanable Funds
($billions)
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22
The Market for Loanable Funds
The demand for loanable funds comes from
investment:
 Firms borrow the funds they need to pay for
new equipment, factories, etc.
 Households borrow the funds they need to
purchase houses.
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23
The Slope of the Demand Curve
A fall in the interest
rate reduces the cost
of borrowing, which
increases the quantity
of loanable funds
demanded.
Interest
Rate
7%
4%
Demand
50
80
Loanable Funds
($billions)
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24
Equilibrium
Interest
Rate
Supply
The interest rate
adjusts to equate
supply and demand.
The eq’m quantity
of L.F. equals
eq’m investment
and eq’m saving.
5%
Demand
60
Loanable Funds
($billions)
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25
Policy 1: Saving Incentives
Interest
Rate
S1
Tax incentives for
saving increase
the supply of L.F.
S2
…which reduces the
eq’m interest rate
5%
4%
and increases the
eq’m quantity of L.F.
(but if T actually
goes down, S shifts
back!)
D1
60 70
Loanable Funds
($billions)
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26
Policy 2: Investment Incentives
Interest
Rate
An investment tax
credit increases the
demand for L.F.
S1
6%
5%
D2
D1
60 70
…which raises the
eq’m interest rate
and increases the
eq’m quantity of L.F.
(but if T actually
goes down, S shifts
back!)
Loanable Funds
($billions)
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27
ACTIVE LEARNING
Budget deficits
2
 Use the loanable funds model to analyze
the effects of a government budget deficit:
 Draw the diagram showing the initial
equilibrium.
 Determine which curve shifts when the
government runs a budget deficit.
 Draw the new curve on your diagram.
 What happens to the equilibrium values of the
interest rate and investment?
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ACTIVE LEARNING
Answers
Interest
Rate
S2
2
A budget deficit reduces
national saving and the
supply of L.F.
S1
6%
5%
D1
50 60
…which increases the
eq’m interest rate
and decreases the
eq’m quantity of L.F.
and private
investment. (But it
may increase public
investment!)
Loanable Funds
($billions)
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Budget Deficits, Crowding Out,
and Long-Run Growth
 Our analysis: Increase in budget deficit may
cause a decline in private investment. The govt
borrows to finance its deficit, leaving less funds
available for private investment.
 This is called crowding out. (This has not been
an important problem in the recent past. )
 Recall from the preceding chapter: Investment
is important for long-run economic growth. If
government borrowing isn’t spent wisely, budget
deficits may reduce the economy’s growth rate
and future standard of living.
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31
The U.S. Government Debt
 The government finances deficits by borrowing
(selling government bonds).
 Persistent deficits lead to a rising govt debt.
 The ratio of govt debt to GDP is a useful
measure of the government’s indebtedness
relative to its ability to raise tax revenue.
 Historically, the debt-GDP ratio usually rises
during wartime and falls during peacetime—until
the early 1980s.
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32
The history of U.S. government debt
 Debt of U.S. federal government
 As a percentage of U.S. GDP
 Fluctuated
 0% of GDP in 1836
 107% of GDP in 1945
 Declining debt-GDP ratio
 Government indebtedness is shrinking relative to
its ability to raise tax revenue
 Government could be living within its means
 Government could also be reducing public
investment
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33
33
The history of U.S. government debt
 Rising debt-GDP
 Government indebtedness is increasing relative
to its ability to raise tax revenue
 Fiscal policy cannot be sustained forever at current
levels
 War – primary cause of fluctuations in government
debt:
 Debt financing of war – appropriate policy
 Tax rates – smooth over time
 Shifts part of the cost to future generations
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34
34
U.S. Government Debt
as a Percentage of GDP, 1790–2010
120%
WW2
100%
63.6% in
2010
80%
60%
Revolutionary
War
Civil
War
WW1
40%
20%
0%
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
The history of U.S. government debt
 President Ronald Reagan, 1981
 Large increase in government debt – not
explained by war
 Committed to smaller government and lower
taxes
 Cutting government spending - more difficult
politically than cutting taxes
 Period of large budget deficits
 Government debt: 26% of GDP in 1980 to 50% of
GDP in 1993
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36
36
The history of U.S. government debt
 President Bill Clinton, 1993
 Major goal - deficit reduction
 And Republicans took control of Congress, 1995
 Deficit reduction
 Substantially reduced the size of the government
budget deficit
 Eventually: surplus
 By the late 1990s: debt-GDP ratio - declining
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37
37
The history of U.S. government debt
 President George W. Bush
 Debt-GDP ratio - started rising again
 Budget deficit
 Several major tax cuts
 2001 recession - decreased tax revenue and
increased government spending
 Spending on homeland security
– Following the September 11, 2001 attacks
– Subsequent wars in Iraq and Afghanistan
– Increases in government spending
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38
38
The history of U.S. government debt
 2008, financial crisis and deep recession
 Dramatic increase in the debt-GDP ratio
 Increased budget deficit
 Several policy measures passed by the Bush and
Obama administrations
 Aimed at combating the recession
 Reduced tax revenue
 Increased government spending
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39
39
The history of U.S. government debt
 2009 and 2010
 Federal government’s budget deficit = 10% of
GDP
 Borrowing to finance budget deficit
 Substantial increase in the debt-GDP ratio
 Policy challenges for future generations
 Putting the federal budget back on a sustainable
path
 Stable or declining debt-GDP ratio
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40
40
Financial Institutions
 The financial system: the group of institutions
that helps match the saving of one person with the
investment of another.
 Financial markets: institutions through which
savers can directly provide funds to borrowers.
Examples:
 The Bond Market.
A bond is a certificate of indebtedness.
 The Stock Market.
A stock is a claim to partial ownership in a firm.
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41
Financial Institutions
 Financial intermediaries: institutions through
which savers can indirectly provide funds to
borrowers. Examples:
 Banks
 Mutual funds – institutions that sell shares to
the public and use the proceeds to buy
portfolios of stocks and bonds
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42
The Meaning of Saving and Investment
 Private saving is the income remaining after
households pay their taxes and pay for
consumption.
 Examples of what households do with saving:
 Buy corporate bonds or equities
 Purchase a certificate of deposit at the bank
 Buy shares of a mutual fund
 Let accumulate in saving or checking accounts
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43
The Meaning of Saving and Investment
 Investment is the purchase of new capital.
 Examples of investment:
 General Motors spends $250 million to build
a new factory in Flint, Michigan.
 You buy $5000 worth of computer equipment
for your business.
 Your parents spend $300,000 to have a new
house built.
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44
CONCLUSION
 Like many other markets, financial markets are
governed by the forces of supply and demand.
 One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
Financial markets help allocate the economy’s
scarce resources to their most efficient uses.
 Financial markets also link the present to the future:
They enable savers to convert current income into
future purchasing power, and borrowers to acquire
capital to produce goods and services in the future.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
45
S U MMA RY
• The supply of loanable funds comes from
saving. The demand for funds comes from
investment. The interest rate adjusts to balance
supply and demand in the loanable funds
market.
• A government budget deficit is negative public
saving, so it reduces national saving, the supply
of funds available to finance investment.
• When a budget deficit crowds out investment,
it reduces the growth of productivity and GDP.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
S U MMA RY
• National saving equals private saving plus
public saving.
• In a closed economy, national saving equals
investment. The financial system makes this
happen.
• The U.S. financial system is made up of many
types of financial institutions, like the stock and
bond markets, banks, and mutual funds.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.