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 assistanceS = (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 su