Kinh tế vĩ mô Chap 4

Chapter 4 Saving, investment and financial system

Mentor Pham Xuan Truong



Content
I Financial system in the economy
II Saving and investment in National Income Account
III The market for loanable funds


I Financial system in the economy
Financial system: Group of institutions in the economy that help match
one person’s saving with another person’s investment

Indirect channel

Capital

Capital

Financial intermediary

Financial system
Lenders

- Households
- Firms
- Government

Borrowers

Capital

Financial market

- Foreign entities

Capital

- Households
- Firms
- Government
- Foreign entities

Direct channel


I Financial system in the economy
+ Direct channel: Financial markets where savers can directly provide funds to borrowers
+ Indirect channel: Financial intermediaries where savers can indirectly provide funds to borrowers

Why we need indirect channel



Decreasing transaction cost



Decreasing cost derived from asymmetric information



Avoiding free driver issue


I Financial system in the economy
Financial institutions
+ Direct channel:
i) The bond market





Bond is the certificate of indebtedness




Interest rate of bond depends on Credit risk of borrowers and term length

Firms raise money by selling bond (loan finance)
Properties of bond: Time of maturity - at which the loan will be repaid; Rate of
interest; Principal - amount borrowed; Term - length of time until maturity
Bond interest and its price: negative relationship (apply: how tax treatment
affects bond interest)

I Financial system in the economy
Financial institutions
+ Direct channel:
ii) The stock market






Stock is the claim to partial ownership in a firm



Stock prices: demand and supply principle

…

Firms raise money by selling stock (equity finance)
Stock is traded in organized stock exchanges
Stock index is an average of a group of stock prices, which sensitively
indicates market conditions


I Financial system in the economy
Financial Institutions
+ Indirect channel:
i) Banks:



Take in deposits from savers (banks pay interest) and make loans to borrowers
(banks charge interest)



Facilitate purchasing of goods and services by creating Checks/ATM card –
medium of exchange

ii) Mutual funds:




…

Institution that sells shares to the public
Uses the proceeds to buy a portfolio of stocks and bonds
Advantages: Diversification and Access to professional money managers.
Disadvantages: Moderate profit and Asymmetric information


II Saving and investment in National Income
Account
Some important identities

Gross domestic product (GDP) or (Y) represents Total income and Total expenditure as well
As we know Y = C + I + G + NX
With closed economy NX = 0, with open economy NX ≠ 0
National saving (S) is the total income in the economy that remains after paying for consumption and

tax (if exist)

We now consider closed economy:

Y=C+I+G

+ S = Y – C – G (by definition), I = Y – C – G (by national income account) → S = I
+ S = (Y – T – C) + (T – G)
while T = taxes minus transfer payments (net tax)


II Saving and investment in National Income
Account
Some important identities

Private saving (Sp), Y – T – C
Income that households have left after paying for taxes and consumption

Public saving (Sg), T – G
Tax revenue that the government has left after paying for its spending
+ Budget surplus: T – G > 0 (Excess of tax revenue over government spending)
+ Budget deficit: T – G < 0 (Shortfall of tax revenue from government spending)

Therefore

Sp + Sg = I or Sp +(T – G) = I

or (Sp – I) + T = G government spending funded by tax collection
and net capital from private sector

II Saving and investment in National Income
Account
Other identities (for Open economy)

We now consider open economy Y = C + I + G + NX
Similarly, we have S = Y – C – G, I + NX = Y – C – G
→ S = I + NX or Sp + Sg = I + NX, Sp + (T – G) = I + (X – M)
or (Sp – I) + (M – X) = G – T budget deficit funded by net capital from private
sector and net foreign inflow

We also have NX = NFI (net foreign investment) therefore
S = I + NFI or S + NDI = I (NDI net domestic investment = - NFI)


III The Market for Loanable Funds
What is the market for loanable funds?
It is the market for Those who want to save supply funds and Those who want to borrow
to invest demand fund
Assumptions
One interest rate that reflects Return to saving and Cost of borrowing
Single financial market
Building the market: Supply and demand of loanable funds
Source of the supply of loanable funds: Saving
Source of the demand for loanable funds: Investment
Price of a loan = real interest rate

 Borrowers pay for a loan
 Lenders receive on their saving

11


III The Market for Loanable Funds
Building the market: Supply and demand of loanable funds
As interest rate rises
Quantity demanded declines
Quantity supplied increases
Demand curve
Slopes downward
Supply curve
Slopes upward

12


The market for loanable funds

Interest
Rate

Supply

5%

Demand

0

$1,200

Loanable Funds
(in billions of dollars)

The interest rate in the economy adjusts to balance the supply and demand for loanable funds. The supply of loanable funds comes from national
saving, including both private saving and public saving. The demand for loanable funds comes from firms and households that want to borrow for
purposes of investment. Here the equilibrium interest rate is 5 percent, and $1,200 billion of loanable funds are supplied and demanded .


III The Market for Loanable Funds
Policies affecting loanable funds
Policy 1: saving incentives
E.g. Shelter some saving from taxation
Affect supply of loanable funds
Increase in supply
Supply curve shifts right
New equilibrium
Lower interest rate
Higher quantity of loanable funds
Greater investment

14


Saving incentives increase the supply of loanable funds

Interest
Supply, S1

Rate

S2

1. Tax incentives for saving increase the supply of

5%

loanable funds . . .

4%
2. . . . Which reduces the

Demand

equilibrium interest rate . . .

0

$1,200

$1,600

Loanable Funds
(in billions of dollars)

3. . . . and raises the equilibrium quantity of loanable funds.
A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right from S 1 to S2. As a result, the equilibrium interest rate
would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of
loanable funds saved and invested rises from $1,200 billion to $1,600 billion.

The Market for Loanable Funds
Policies affecting loanable funds
Policy 2: investment incentives
E.g. Investment tax credit

Affect demand for loanable funds
Increase in demand
Demand curve shifts right
New equilibrium
Higher interest rate
Higher quantity of loanable funds
Greater saving
16


Investment incentives increase the demand for loanable funds

Interest
Rate

Supply
1. An investment tax credit increases the

6%

demand for loanable funds . . .
5%

2. . . . which

raises the

D2

equilibrium

Demand, D1

interest rate . . .
0

$1,200

$1,400

Loanable Funds
(in billions of dollars)

3. . . . and raises the equilibrium quantity of loanable funds.
If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate
would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D 1 to D2, the equilibrium interest rate rises from 5 percent to 6
percent, and the equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,400 billion.


The Market for Loanable Funds
Policies affecting loanable funds
Policy 3: government budget deficits and surpluses
Government - starts with balanced budget
E.g. Then starts running a budget deficit by increasing spending or
decreasing tax

Change in supply of loanable funds
Decrease in supply
Supply curve shifts left

New equilibrium
Higher interest rate
Smaller quantity of loanable funds
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The effect of a government budget deficit

Interest

S2

Rate

6%

Supply, S1

1. A budget deficit decreases the supply of loanable
funds . . .

5%
2. . . . which
raises the
Demand

equilibrium
interest rate . . .

0

$800

$1,200

Loanable Funds
(in billions of dollars)

3. . . . and reduces the equilibrium quantity of loanable funds.
When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the
equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance
investment. Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds
saved and invested falls from $1,200 billion to $800 billion.


III The Market for Loanable Funds
Policies affecting loanable funds
Policy 3: government budget deficits and surpluses

Government - budget deficit
Interest rate rises
Investment falls
Crowding out effect
Decrease in investment
Results from government borrowing

(Analyze the situation when government runs budget surplus)

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Key concepts


Financial system



Financial market



Financial intermediary



Bond market, stock market



Investment saving identity



Loanable fund market



Budget deficit, budget balance, budget surplus



Crowding – out effect