ECN 204 Lecture Notes - Loanable Funds, Unemployment Benefits, Investment Canada
Chapter 8 Saving, Investment, and the Financial System
Financial System: the group of institutions in the economy that help to match one person’s saving with
another person’s investment
Financial Markets: are institutions through which a person who wants to save can directly supply funds
to a person who wants to borrow.
Two most important financial markets:
The Bond Market
Bond: a certificate of indebtedness that specifies the obligation of the borrower to the holder of
the bond. It identifies the time at which the loan will be repaid (date of maturity), rate of
interest that would be paid periodically until the loan matures.
-Sale of a bond = debt finance
Bond’s Term: the length of time until the bond matures. Long term bonds usually pay higher
interest rate than short term bonds
Credit Risk: the probability that the borrower will fail to pay some of the interest or principle; a
failure to pay is called a default.
The Stock Market
Stock: represents ownership in a firm and is therefore a claim to the profits that the firm makes.
-Sale of a stock = equity finance
-higher risk but potentially higher returns
Financial Intermediaries: financial institutions through which savers can indirectly provide funds to
-offer loans, primary job of bank is to take in deposits from people who want to save and use
these deposits to make loans to people who want to borrow
-Banks also help create a special asset that people can use as a medium of exchange (writing
-an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks
-primary advantage is it allows people to diversify
-some mutual funds have “professional managers” that keep track of stocks/bonds
Saving and Investment in the National Income Accounts
Identities: is an equation that must be true because of the way the variables in the equation are defined
I = Y – C – G (total income in the economy after paying for consumption and government purchases) can
be denoted S) therefore it can also be S = I (saving equals investment)
National Saving (S): the total income in the economy that remains after paying for consumption and
T= the amount that the government collects from households in taxes minus the amount it pay backs to
households in the form of transfer payments which are employment insurance and social assistance
S = (Y – T – C) + (T – G)
Private Saving (Y – T – C): the income that households have left after paying for taxes and consumption.
They receive income of Y, pay taxes of T, and spend C on consumption
Public Saving (T – G): the tax revenue that the government has left after paying for its spending.
Government receives T in tax revenue and spends G on goods and services.
Budget Surplus: an excess of tax revenue over government spending (if T is greater than G)
Budget Deficit: a shortfall of tax revenue from government spending (G is greater than T)
#1: Suppose GDP equals $10 million, consumption equals $6.5 million, the government spends $2
million and has a budget deficit of $300 million
Answer: Y= 10, C=6.5, G=2, G-T=0.3
Public Saving (T-G) = -0.3
Taxes =T= G-0.3= 1.7
Private Saving= (Y-T-C) = 10-1.7-6.5= 1.8
National Saving (Y-C-G)= 10-6.5- 2 = 1.5
Investment = National Saving = 1.5
2#: Find public saving, taxes, private saving, national saving, and investment. Use the numbers from
the preceding exercise, but suppose now that the government cuts taxes by $200 milion
-a tax cut will cause consumption to rise and national savings to fall
The Market for Loanable Funds
-the market in which those who want to save supply funds and those who want to borrow to invest
-the interest rate is the price of the loan, it represents the amount that borrowers pay for loans and the
amount that lenders receive on their savings.
-if interest rate rises, quantity demanded decreases (demand curve for Loanable funds slopes downward,
and the supply curve for Loanable funds slopes upward
-we use real interest rate because it corrects for inflation
Policy 1: Saving Incentives
Note: If a reform of the tax laws encouraged greater saving, the result would be lower interest rates and
-Canada should raise its saving rate to the level that prevails in other countries, the growth rate of GDP
would increase and overtime, Canadian citizens would enjoy a higher standard of living
-people save less in Canada because government taxes
-the Federal goods and service tax (GST) promotes saving because it taxes only on consumption not on
-The tax system encourages people to save therefore it would affect the quantity of loanable funds
SUPPLIED, thus the supply of loanable funds would SHIFT to the right. The equilibrium interest rate
would fall, and the lower interest rate would stimulate investment.
. The demand for loanable funds would remain the same because tax change foes not directly affect the
amount that borrowers want to borrow.
Policy 2: Investment Incentives
Note: If a reform of the tax laws encouraged greater investment, the result would be higher interest
rates and greater savings
-Sometimes Parliament institutes an investment tax credit that gives a tax advantage to any firm
building a new factory or buying a new piece of equipment.
-It will shift the demand for loanable funds to the right because firms would have an incentive to
increase investment at any interest rate.
-The equilibrium interest rate would rise, and the higher interest rate would stimulate saving
Policy 3: Government Budget deficits and Surpluses
Note: when the government reduces national saving by running a budget deficit, the interest rate rises,
and the investment falls. Because investment is important to long term economic growth, government
budget deficits reduce the economy growth rate
Note: A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates
Government Budget Deficit: when a government spends more than it receives in tax revenue
Government Budget Surplus: when a government spends less than it receives in tax revenue
Balanced Budget: when a government spends exactly what it receives in tax revenue
Government Debt: the sum of all past budget deficits minus the sum of all budget surpluses
-When the government starts running a budget deficit, it does not affect the demand for loanable funds
because it does not influence the amount that households and firms want to borrow. The supply of
loanable funds decreases and the equilibrium interest rate rises.
-When the government borrows to finance its budget deficit, it reduces the supply of loanable funds
available to finance investments by households.
-Budget Deficit shifts the supply curve for loanable funds to the LEFT
Crowding Out: a decrease in investment that results from government borrowing
Vicious Cycle: cycle that results when deficits reduce the supply of loanable funds, increase interest
rates, discourage investment, and result in slower economic growth; slower growth leads to lower tax
revenue and higher spending on income support programs, and the result can be even high budget
Virtuous Circle: cycle that results when surpluses increase the supply of loanable funds, reduce interest
rates, stimulate investment, and result in faster economic growth; faster growth leads to higher tax
revenue and lower spending on income support programs, and the result can be even higher budget