Saving, investment and financial system (KINH tế vĩ mô 1)

Chapter 4 - Saving,
investment and financial
system


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

Lenders
- Households
- Firms
- Government
- Foreign entities

Capital

Financial intermediary

Financial system

Capital

Financial market

Direct channel

Capital

Borrowers
- Households
- Firms
- Government
- Foreign entities


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
 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
 Interest rate of bond depends on Credit risk of
borrowers and term length
 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
 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
 Stock prices: demand and supply principle
…


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
Rate

Supply, S1
S2
1. Tax incentives for saving
increase the supply of

loanable funds . . .

5%
4%
2. . . . Which
reduces the
equilibrium
interest rate . . .

Demand

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 S1 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 demand for
loanable funds . . .

6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .

D2
Demand, D1

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.
0

$1,200 $1,400


The Market for Loanable
Fundsaffecting loanable funds
Policies

18

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


The effect of a government budget deficit
Interest
Rate

S2

6%

Supply, S1
1. A budget deficit decreases
the supply of loanable funds . .
.

5%
2. . . . which
raises the
equilibrium
interest rate . . .

Demand

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.
0

$800 $1,200


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)
20


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