Chapter 7: Savings and Investment

Objectives

• Determinants of saving, investment, and interest rates

• Effect of government budget deficits on financial markets, saving and investment

• Effect of international borrowing and lending on interest rates, saving and investment.

Physical Capital vs. Financial Capital

Physical capital • Tools, instruments, machines, buildings, and other

items that have been produced in the past and that are used today to produce goods and services.

Financial capital • The funds that firms use to buy physical capital.

Capital and Investment

Gross investment • total amount spent on purchases of new capital

and on replacing depreciated capital.Depreciation (capital consumption allowance)

• decrease in the quantity of capital that results from wear and tear and obsolescence.

Net investment • change in the quantity of capital.• gross investment depreciation

Wealth and Saving

Wealth • the value of all the things that people own.

Saving • the amount of income that is not paid in taxes or

spent on consumption goods and services. Wealth increases with

• Saving• Capital gains

Wealth is decreased by capital losses.Wealth(t) = Wealth(t-1)+saving(t-1)+ capital gains(t-1)

Markets for financial capital

Saving is the source of funds used to finance investment.

These funds are supplied and demanded in three types of financial markets:

• Loan markets• Bond markets• Stock markets

Financial Institutions and markets

Financial institution

•a firm that that operates on both sides of the markets for financial capital. •borrower in one market and a lender in another.

Types of financial institutions• Investment banks• Commercial banks• Government-sponsored mortgage lenders• Pension funds• Insurance companies

The Market for Loanable Funds

The market for loanable funds is the aggregate of all the individual financial markets.

Funds that Finance Investment

1. Household saving S

2. Government budget surplus (T –Tr – G)

3. Borrowing from the rest of the world (M – X)

Because Income Side of GDP = Expenditure Side of GDP

C + S + (T-Tr) = C + I + G + (X-M)

I = S + (T-Tr) - G + (M-X)

The Market for Loanable Funds

The market for loanable funds • the market in which households, firms,

governments, and financial institutions borrow and lend.

• The market influences– Saving and investment– Interest rates

The Market for Loanable Funds

Nominal interest rate • More specific name for “interest rate”• Not adjusted for effects of inflation• $ of interest / $ of loan

Real interest rate • nominal interest rate adjusted to remove the effects

of inflation on the purchasing power of money.• nominal interest rate minus the inflation rate.

The Market for Loanable Funds

Demand for loanable funds

• the relationship between the quantity of loanable funds demanded and the real interest rate, ceteris paribus.

• Business investment is the main item that makes up the demand for loanable funds.

The Market for Loanable Funds

Changes in the Demand for Loanable Funds

(a shift in the demand curve)

When expected profits rises (falls), the demand for loanable funds rises (falls)

Tax policy can affect demand for loanable funds• Investment tax credit• Accelerated depreciation.

The Market for Loanable Funds

The supply of loanable funds

• the relationship between the quantity of loanable funds supplied and the real interest rate, ceteris paribus.

• Saving is the main item that makes up the supply of loanable funds.

The Market for Loanable Funds

The Market for Loanable Funds

Changes in the supply of loanable funds

• Temporary changes in disposable income• Expected future income• Wealth• Perceived default risk of borrowers

The Market for Loanable Funds: Equilibrium

• Assuming no government or international sector,

• SLF= Saving• DLF=Investment

• What’s the effect of decline in future expected profits on

• Saving & Investment• Real interest rate

The Market for Loanable Funds

Government in the Market for Loanable Funds

Government enters the loan market when it has a budget surplus or deficit.

• A government budget surplus increases the supply of funds

• A government budget deficit increases the demand for funds.

Government Surplus in the Market for Loanable Funds

Government Deficit in the Market for Loanable Funds

Government in the Market for Loanable Funds: Ricardo-Barro Effect

The Global Loanable Funds Market

• The loanable funds market is global, not national.

• Financial capital is mobile: It moves to the best advantage of lenders and borrowers.

• Because lenders are free to seek the highest real interest rate and borrowers are free to seek the lowest real interest rate, the loanable funds market is a single, integrated, global market.

• Funds flow into the country in which the real interest rate is highest and out of the country in which the real interest rate is lowest.

The Global Loanable Funds Market

International Borrowing and Lending

If a country’s net exports are negative, • Country is a net borrower• quantity of loanable funds in that country is greater

than national saving. If a country’s net exports are positive,

• the country is a net lender• the quantity of loanable funds in that country is less

than national saving.

The Global Loanable Funds Market