ECON 1BB3 Study Guide - Midterm Guide: Loanable Funds, Autarky, Byrsonima Crassifolia
Course CodeECON 1BB3
ProfessorBridget O' Shaughnessy
Savings, Investment and the Financial System
January 11, 2005
Reading: Chapter 13 of Mankiw et. al. (2002). [Chapter 8 of brief edition.]
Financial system - the group of institutions in the economy that help to match one person’s
savings with another person’s investment.
⇒some people want to save some of income for future.
⇒some people want to borrow in order to ﬁnance investments in new and growing
What brings two together?
What ensures that supply of funds (savings) equals demand for funds for investment.
2 Financial markets
- ﬁnancial institutions through which savers can directly provide funds to borrowers.
Types of ﬁnancial markets:
1. The Bond Market
ﬁrms/government can borrow money by selling bonds.
bond - a certiﬁcate of indebtedness.
date of maturity - time at which loan will be repaid.
bonds generally pay interest annually until loan matures.
Characteristics of bonds:
(a) term - length of time until bond matures
aperpetuity is a bond that never matures, pays interest forever.
(b) credit risk - probability borrower will fail to pay some of interest or principal.
→borrowers need higher interest rate to buy risky bonds.
Bonds can be sold if holder requires principal before maturity, but may involve a
2. The Stock Market - ﬁrms sell stock in company.
stock - a claim to partial ownership in the ﬁrm.
shareholders have claim to share of ﬁrm’s proﬁts if any
⇒if ﬁrm fails, has ﬁnancial diﬃculties, bondholders are paid what they are due before
stockholders receive anything.
Debt ﬁnance - money raised through sale of bonds.
Equity ﬁnance - money raised through sale of stocks.
stock prices depend in part on people’s expectations about a company’s future.
3 Financial Intermediaries
-ﬁnancial institutions through which savers can directly provide funds to borrowers.
Types of ﬁnancial institutions:
1. Banks - bank takes in deposit of those who wish to save and uses deposits to make
loans to those who wish to borrow.
higher interest charged to borrower than is paid to saver - diﬀerence is used to cover
operating costs, pay out proﬁts to owners of bank.
2. Mutual Funds - an institution that sells shares to public and uses the proceeds to buy
a portfolio of stocks and bonds.
⇒allows people with small amounts of money to diversify.
4 Savings and Investment in the National Accounts
Y=C+I+G+N X (1)
This equation is an identity - always holds because of the way the variables are deﬁned.
For now we will consider a closed economy - an economy that does not interact with other
In a closed economy, N X = 0 (i.e. no net exports). Hence
Every unit of output sold in a closed economy is either consumed, invested or brought by
Can rewrite as
Left-hand side (Y−C−G) is called national saving, or saving, and is denoted as S.
National Saving (S) - total income in economy that remains after paying for consumption
and gov’t purchases. Saving can be divided into two parts. Adding and subtracting T (taxes)
to the right hand side of (3) yields
S= (Y−C−T)+(T−G) (5)
The ﬁrst term (Y−C−T) is called private saving and the second term (T−G)is called
private saving - income that households have left after paying for taxes and consumption.
public saving - tax revenues that gov’t has left after paying for goods and services.
•If T=G, gov’t runs balanced budget.
•If T < G, gov’t runs budget deﬁcit.
•If T > G, gov’t runs budget surplus.
4.1 The Meaning of Saving and Investment
In economics, setting aside unused income for future use (and interest income) is saving.
e.g. buying a stock in Ford is saving, not investment
In economics, investment refers to purchase of new capital.
e.g. when Ford using proceeds of new stock issues to purchase new factory, this is