8

Saving, Investment, and the Financial System

The Financial System

The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment.

It moves the economy’s scarce resources from savers to borrowers.

FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY

The financial system is made up of financial institutions that coordinate the actions of savers and borrowers.

Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.

Financial Markets

Stock Market

Bond Market

Financial Intermediaries

Banks

Mutual Funds

Insurance companies

Pension plans

Etc.

Financial markets are the institutions through which savers can directly provide funds to borrowers.

Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

Financial Markets

The Bond Market

A bond is a certificate of indebtedness that
specifies obligations of the borrower to
the holder of the bond.

The Stock Market

Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes.

The sale of stock to raise money is called equity financing.

Compared to bonds, stocks offer both higher risk and potentially higher returns.

The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.

Most newspaper stock tables provide the following information:

Price (of a share)

Volume (number of shares sold)

Dividend (profits paid to stockholders)

Price-earnings ratio

Financial Intermediaries

Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

Banks

take deposits from people who want to save and use the deposits to make loans to people who want to borrow.

pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.

Banks help create a medium of exchange by allowing people to write checks against their deposits.

A medium of exchanges is an item that people can easily use to engage in transactions.

This facilitates the purchases of goods and services.

Mutual Funds

A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both.

They allow people with small amounts of money to easily diversify.

Other Financial Institutions

Credit unions

Pension funds

Insurance companies

Loan sharks

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS

Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:

Y = C + I + G + NX

Some Important Identities

Assume a closed economy – one that does not engage in international trade:

Y = C + I + G

Now, subtract C and G from both sides of the equation:

Y – C – G =I

The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

Substituting S for Y - C - G, the equation can be written as:

S = I

National saving, or saving, is equal to:

S = I

S = Y – C – G

S = (Y – T – C) + (T – G)

The Meaning of Saving and Investment

National Saving

National saving is the total income in the economy that remains after paying for consumption and government purchases.

Private Saving

Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.

Private saving = (Y – T – C)

Public Saving

Public saving is the amount of tax revenue that the government has left after paying for its spending.

Public saving = (T – G)

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.

For the closed economy as a whole, saving must be equal to investment.

S = I

Summary

The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds.

All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.

National income accounting identities reveal some important relationships among macroeconomic variables.

In particular, in a closed economy, national saving must equal investment.

Financial institutions attempt to match one person’s saving with another person’s investment.

National saving equals private saving plus public saving.

A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds.

When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.