Transcript Module 22 Saving and Investment

Saving, Investment,
and the Financial
System
Module 22
Saving and Investment in the
National Income Accounts
Recall that GDP is both total income
(Y) in an economy and total
expenditure (C+I+G+NX) on the
economy’s output of goods and
services:
Y = C + I + G + NX
Saving-Investment Identity
Assume a closed economy (one that
does not engage in international
trade) and one without government
involvement:
Total income = Total spending
Y=C+I
Saving-Investment Identity
• Remember you can do two things with
your income: save it or spend it
Y = Consumption + Savings
C+S=C+I
Saving-Investment Identity
•
Removing Consumption from both
sides reveals that for the economy as
a whole, the money that is available
for businesses to borrow in order to
buy capital (investment) is our
savings.
S=I
Adding Government to Equation
• Government spends on goods, services
and transfer payments and collects tax
revenue to pay for these things
• If the government budget is balanced
Tax Revenue = Government Spending
Budget Balance (BB) =
Tax Revenue – Government Spending
Saving-Investment Identity
• If BB > 0, the government has a budget
surplus and is SAVING money
• If BB < 0, the government has a budget
deficit and is BORROWING money
• Adding government saving (public saving)
to private saving equals national savings
S + BB = I
Private savings + Public savings = Investment
• If government has a surplus I will increase
• If government has a deficit I will decrease
Adding Foreign Sector
• An American can save in the US or in a
foreign country and a foreign citizen can
save in their country or in the US
• The US receives inflows of funds--foreign
savings that finance Investment spending
• The US also generates outflows of funds-US savings that finance foreign
Investment spending
Saving-Investment Identity
Capital Inflow into the US =
total inflow of foreign funds – total outflow of
domestic funds to other countries
• Capital inflows can be positive or negative
This leads to:
S + BB + CI = I
If CI > 0 then Investment must increase
If CI < 0 then Investment must decrease
The Loanable Funds Market
Chapter 13
The Market for Loanable Funds
•Financial markets coordinate the
economy’s saving and investment in
the market for loanable funds.
•Loanable funds refers to all income
that people have chosen to save and
lend out, rather than use for their
own consumption.
Supply and Demand for Loanable
Funds
•
The supply of loanable funds comes from
people who have extra income they want
to save and lend out (savings).
•
The demand for loanable funds comes
from households and firms that wish to
borrow to make investments (borrowing) .
Market for Loanable Funds...
Real
Interest
Rate
Supply (savings)
4%
Demand (borrowing)
0
$1,000
Loanable Funds (in
billions of dollars)
Supply and Demand for Loanable Funds
The interest rate is the price of the loan.
• It represents the amount that borrowers
pay for loans and the amount that
lenders (savers) receive on their saving.
• As interest rates rise savers will be more
willing to save and vice versa.
• As interest rates fall borrowers will be
more willing to borrow and vice versa.
•
Market for Loanable Funds
Real Interest
Rates
6%
Quantity of
loanable funds
supplied
1400
Quantity of
loanable funds
demanded
600
5%
1200
800
4%
1000
1000
3%
800
1200
2%
600
1400
Interest Rates and the Loanable Funds
Market
•
•
The interest rate in the market for loanable
funds is the real interest rate.
The equilibrium of the supply and demand
for loanable funds determines the real
interest rate
Market for Loanable Funds...
Real
Interest
Rate
Supply (savings)
4%
Demand (borrowing)
0
$1,000
Loanable Funds (in
billions of dollars)
An Increase in the Supply of
Loanable Funds
• Households decide to save more of
their income which
– Reduces the equilibrium interest rate
and
– Raises the equilibrium quantity of
loanable funds
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
An Increase in the Supply of
Loanable Funds...
Interest
Rate
Supply, S1
S2
1. Households
decide to save more
of their income.
4%
3%
Demand
2. ...which
reduces the
equilibrium
interest rate...
0
$1,000
Loanable Funds
$1,200
(in billions of dollars)
3. ...and raises the equilibrium quantity of loanable funds.
An Increase in the Demand for
Loanable Funds
• Businesses decide to now is a good
time to invest in plants and equipment
so they demand more loans
– Increases the equilibrium interest rate
and
– Raises the equilibrium quantity of
loanable funds
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
An Increase in the Demand for
Loanable Funds...
Interest
Rate
5%
4%
2. ...which
raises the
equilibrium
interest rate...
0
Supply
1. Businesses decide
now is a good time to
invest in plants &
equipment
D2
Demand, D1
$1,200
$1,000
Loanable Funds
(in billions of dollars)
3. ...and raises the equilibrium
quantity of loanable funds.
Factors that affect Supply and
Demand for Loanable Funds
• There are several factors that affect
the supply and demand for loanable
funds. Two of them are:
– Taxes
– Government deficits and surpluses
Taxes and Saving
•Taxes on interest income
substantially reduce the future payoff
from current saving and, as a result,
reduce the incentive to save. The
result will be higher interest rates and
smaller investment
•If a change in tax law encourages
greater saving, the result will be lower
interest rates and greater investment.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
An Increase in the Supply of
Loanable Funds...
Interest
Rate
Supply, S1
S2
1. Households
decide to save more
of their income.
4%
3%
Demand
2. ...which
reduces the
equilibrium
interest rate...
0
$1,000
Loanable Funds
$1,200
(in billions of dollars)
3. ...and raises the equilibrium quantity of loanable funds.
Taxes and Investment
If a change in tax laws encourages
greater investment (a reduction in the
capital gains tax), the result will be
higher interest rates and greater saving.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
An Increase in the Demand for
Loanable Funds...
Interest
Rate
6%
5%
2. ...which
raises the
equilibrium
interest rate...
0
Supply
1. An investment tax
credit increases the
demand for loanable
funds...
D2
Demand, D1
$1,400
$1,200
Loanable Funds
(in billions of dollars)
3. ...and raises the equilibrium
quantity of loanable funds.
Government Budget Deficits and
Surpluses
•
•
•
Government borrowing to finance its
budget deficit reduces the supply of
loanable funds available to finance
investment by households and firms.
Interest rates rise and investment falls.
This fall in investment is referred to as
crowding out.
 The
deficit borrowing crowds out private
borrowers who are trying to finance
investments.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Effect of a Government Budget
Deficit...
Interest
Rate
S2
6%
5%
2. ...which
raises the
equilibrium
interest rate...
$800
$1,200
0
3. ...and reduces the equilibrium
quantity of loanable funds.
Supply, S1
1. A budget deficit
decreases the
supply of loanable
funds...
Demand
Loanable Funds
(in billions of dollars)
Surplus and Deficit
•
•
•
•
If T>G, the government runs a budget
surplus because it receives more
money than it spends.
The surplus of T-G represents public
saving.
If G>T, the government runs a budget
deficit because it spends more money
than it receives in tax revenue.
The deficit of T-G represents a reduction
in public saving