The Financial System: Saving, Investment, and the Market for Loanable Funds

The Financial System

Introduction to the Financial System

The financial system consists of institutions that facilitate the flow of funds from savers to investors, helping match the saving of one person with the investment of another. It plays a crucial role in the allocation of resources and the functioning of the macroeconomy.

• Financial markets: Institutions where savers can directly provide funds to borrowers. Examples include the bond market and the stock market.

• Financial intermediaries: Institutions where savers provide funds indirectly to borrowers, such as commercial banks and mutual funds.

Financial Markets

The Bond Market

The bond market is a primary financial market where bonds, which are certificates of indebtedness, are issued and traded.

• Bonds are identified by:

  • Date of maturity: The date when the loan is repaid.

  • Yield: The interest rate paid to the bondholder.

  • Principal: The amount originally borrowed.

• Bonds differ by three key characteristics:

  1. Term: Length of time until the bond matures (e.g., perpetuity).

  2. Credit risk: Probability that the borrower will default.

  3. Tax treatment: How tax laws view interest income (e.g., municipal bonds may be tax-exempt).

The Stock Market

The stock market is where shares of ownership in firms are bought and sold.

• Stock entitles owners to a share of the firm's profit.

• Equity finance: Raising capital by selling stock.

• Debt finance: Raising capital by selling bonds.

• Stocks are traded on organized exchanges after corporations go public (I.P.O.), such as NYSE and NASDAQ.

• Equity finance generally offers higher risk and higher average return compared to debt finance.

Reading Stock Tables

Stock tables provide key information for investors:

1. Price: Cost of a single share.

2. Dividend: Share of profits paid out to stockholders.

3. PE Ratio: Share price divided by earnings per share.

Stock tables are widely available online (e.g., Bloomberg).

Financial Institutions

Financial Intermediaries

Financial intermediaries facilitate the indirect flow of funds from savers to borrowers.

• Commercial banks: Accept deposits and make loans, reducing search and monitoring costs, and creating a medium of exchange.

• Mutual funds: Sell shares to the public and use proceeds to buy a diversified portfolio of stocks and bonds, allowing savers to diversify their investments.

Saving in the Economy

Different Kinds of Saving

Saving is categorized into private and public saving:

• Private saving: The portion of households’ income not used for consumption or paying taxes. $Y - T - C$

• Public saving: Tax revenue less government spending. $T - G$

Budget Deficits and Surpluses

• Budget surplus: Excess of tax revenue over government spending. $T - G$

• Budget deficit: Shortfall of tax revenue from government spending. $G - T = - (T - G)$

National Saving

National saving is the sum of private and public saving, representing the portion of national income not used for consumption or government purchases.

• $ext{National saving} = ext{Private saving} + ext{Public saving}$

• $= (Y - T - C) + (T - G)$

• $= Y - C - G$

Saving and Investment

National Income Accounting Identity

The national income accounting identity for a closed economy is:

• $Y = C + I + G$

• Solve for investment: $I = Y - C - G = (Y - T - C) + (T - G)$

• In a closed economy, saving equals investment.

Calculation Example

Suppose GDP ($Y$) is $10$trillion, consumption ($C$) is $6.5$ trillion, government spending ($G$) is $2$trillion, and the budget deficit ($G-T$) is $0.3$ trillion.

• Find public saving, taxes, private saving, national saving, and investment.

• Given: $Y = 10.0$, $C = 6.5$, $G = 2.0$, $G - T = 0.3$

• Public saving: $T - G = -0.3$

• Taxes: $T = G - 0.3 = 2.0 - 0.3 = 1.7$

• Private saving: $Y - T - C = 10.0 - 1.7 - 6.5 = 1.8$

• National saving: $1.8 + (-0.3) = 1.5$

• Investment: $1.5$

The Meaning of Saving and Investment

Private Saving

Private saving is the income remaining after households pay taxes and consumption expenses.

• Households may:

  • Buy corporate bonds or equities

  • Purchase certificates of deposit at banks

  • Buy shares of mutual funds

  • Let funds accumulate in savings or checking accounts

Investment

In economics, investment refers to the purchase of new capital, not the purchase of stocks and bonds.

• Examples:

  • Corporations building new factories

  • Businesses buying equipment

  • Households building new homes

The Market for Loanable Funds

Overview

The market for loanable funds is a supply-demand model that explains how the financial system coordinates saving and investment, and how government policies affect interest rates.

• Assume a single financial market with one interest rate.

• All savers deposit their savings; all borrowers take out loans.

• The interest rate is both the return to saving and the cost of borrowing.

Supply of 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 supply; if negative, reduces supply.

The Slope of the Supply Curve

An increase in the interest rate makes saving more attractive, increasing the quantity of loanable funds supplied.

Demand for Loanable Funds

The demand for loanable funds comes from investment:

• Firms borrow funds for new equipment, factories, etc.

• Households borrow funds to purchase new houses.

The Slope of the Demand Curve

A fall in the interest rate reduces the cost of borrowing, increasing the quantity of loanable funds demanded.

Equilibrium in the Market for Loanable Funds

The interest rate adjusts to equate supply and demand. The equilibrium quantity of loanable funds equals equilibrium investment and saving.

Policy Effects on the Market for Loanable Funds

Policy 1: Saving Incentives

Tax incentives for saving increase the supply of loanable funds, reducing the equilibrium interest rate and increasing the equilibrium quantity of loanable funds.

Policy 2: Investment Incentives

An investment tax credit increases the demand for loanable funds, raising the equilibrium interest rate and increasing the equilibrium quantity of loanable funds.

Policy 3: Government Budget Deficits

A budget deficit reduces national saving and the supply of loanable funds, increasing the equilibrium interest rate and decreasing the equilibrium quantity of loanable funds.

Budget Deficits, Crowding Out, and Long-Run Growth

Crowding Out Effect

An increase in the budget deficit causes a fall in investment, as the government borrows to finance its deficit, leaving less funds available for private investment. This phenomenon is called crowding out.

• Investment is crucial for long-run economic growth.

• Budget deficits reduce the economy's growth rate and future standard of living.

Summary Table: Key Formulas

Concept	Formula (LaTeX)
Private Saving	$Y - T - C$
Public Saving	$T - G$
National Saving	$(Y - T - C) + (T - G) = Y - C - G$
Investment (Closed Economy)	$I = Y - C - G$
Budget Surplus	$T - G$
Budget Deficit	$G - T$

Additional info: Academic context and examples have been expanded for clarity and completeness.