Chapter 8 – Saving, Investment and the Financial System
What is a financial system?
Financial system – the group of institutions in the economy that help to match one person’s
savings with another person’s investment
Financial institutions in the Canadian economy (Page 166 to 171)
• At the broadest level, the financial system moves the economy’s scares resources from
savers to borrowers
• Savers supply money to the financial system with the expectation of earning interest
• The financial system is made up of various financial institutions that coordinate savers
• Office of the Superintendent of Financial Institutions (OFSI) - the primary regulator of
federally regulated banks, insurance companies and pension plans in Canada.
• Bank of Canada – plays an important role in regulating the Canadian financial system.
What is a financial market? (Page 167)
Financial markets – financial institutions through which savers can directly provide funds to
borrowers. The most important ones in our economy are the bond and stock markets.
The Bond Market (Page 167 to 168)
• Bond – a certificate of indebtedness that specifies the obligations of the borrower to the
holder of the bond. (Borrowing $ directly from the public)
o Identifies date of maturity and the rate of interest
• Two characteristics of bonds are very important:
o Bond term – the length of time until the bond matures
o Credit risk – the probability that the borrower will fail to pay some of the interest
or principal. (such a failure to pay is called a default)
• Sale of bonds is called debt finance
• When someone buys bonds, they become a creditor. Bondholders only receive their
interest back as well as their principle.
• If company gets into trouble, bondholders are paid before shareholders.
The Stock Market (Page 168 to 170)
• Another way for a company to raise funds is to sell stocks in the company
• Stock – represents a claim to part-ownership in a firm
• Sale of stock to raise money is called equity finance. The owner of a ‘share’ is a part-
owner. Shareholders can reap the benefits and harms of being a part-owner, including a
share of the profit.
• Stock index – an average of a group of stock prices. These monitor the overall level of
stock prices. (Ex: Dow Jones industrial average or S&P/TSX Composite Index)
Financial intermediaries (Page 170 to 171)
Financial intermediaries – Financial institutions through which savers can indirectly provide
funds to borrowers. The most important ones are banks and mutual funds.
Banks (Page 170) • A primary job of banks 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 pay depositors interest and charge borrowers a slightly higher interest rate on
their loans. The difference between these rates covers the bank’s costs and provides
profit for owners of the bank.
• Also, bank facilitates purchases of goods and services by allowing people to write
cheques against their deposits.
Mutual Funds (Page 170 and 171)
• An institution that sells shares to the public and uses the proceeds to buy a portfolio of
stocks and bonds
• Shareholder of a mutual fund accepts all the risk and return associated with the portfolio
• This allows people with small amount of money to diversify. People who hold a diverse
portfolio of stocks and bonds face less risk because they only have a small stake in
• Mutual funds also give ordinary people access to the skills of professional money
managers. (however, economists are often skeptical of this point)
Saving and the Investment in the National Income Accounts (Page 171 to 173)
• Events that occur in the financial system are central to the developments in the overall
• Saving and investment are important determinants of long-run growth in GDP and living
• Accounting – refers to how various numbers are defined and added up
Some important identities (Page 173 and 174)
• Y = C + I + G + NX (Calculation of GDP)
• Closed economy – one that does not interact with other economies. Actual economies
are open economies they interact with other economies around the world. In a closed
Y = C + I + G
• Net national saving (saving) – the total income in the economy that remains after paying
for consumption and government purchases
o Y – C – G = I(S) (S = I, in other words, saving equals investment)
• S = Y – C – G or S = (Y – T – C) + (T – G)
o These equations are the same, however, the second equation separates national
saving into two pieces: private saving and public saving
o Private saving – the income that households have left after paying for taxes and
consumption (Y – T – C)
o Public saving – the tax revenue that government has left after paying for its
spending (T – G) T is tax revenue and G is amount spent on Goods and services
Budget surplus – an excess of tax revenue over government spending
Budget deficit – a shortfall of tax revenue from government spending
• FOR THE ECONOMY AS A WHOLE, SAVING MUST EQUAL TO INVESTMENT. The
financial system coordinates how much to save and how much people invest.
The Meaning of Saving and Investment (Page 174 and 175)
• Investment refers to the purchase of new capital such as equipment or buildings • S = I for entire economy but does not have to be true for every individual firm or
The Market for Loanable Funds (Page 175 to 183)
• Market for loanable funds – The market in which those who want to save supply funds
and those who want to borrow to invest demand funds. All savers go to this market to
deposit their saving and all borrowers go to this market to get their loans.
• Loanable funds – the income that people have chosen to save and lend out, rather than
use for their own consumption.
Supply and Demand for Loanable Funds (Page 175 to 177)
• Market for loanable funds is governed by supply and demand
• Supply of loanable funds comes from people who have some extra income they want to
save and lend out (Can occur directly or indirectly) – saving is supply of funds
• Demand of funds comes from households and firms who wish to borrow to make
investments. – Investment is the source of the demand for loanable funds.
• Interest rate is the price of a loan – the amount that borrowers pay for loan and the
amount lenders receive on their saving.
o High interest rate – quantity of loanable funds demanded will fall as interest rate
o Demand curve for loanable funds supplied downward and the supply curve
o Equilibrium is the interest rate which balances the quantity supplied and
• The real interest more accurately reflects the real return to saving and cost of borrowing.
In rest of the chapter when we see interest rate, it is talking about real interest rate.
There are various government policies that affect the economy’s saving and investment:
Policy 1 – Saving Incentives (Page 177 to 179)
• Low saving rate is partly attributable to tax laws that discourage saving. Economists
• Due to this government introduced GST – a consumption tax, therefore savings were not
• RRSP reduces the amount of income that is subject to tax
• Tax free savings account is not subject to tax, people are given incentive to save
• Change in tax laws to encourage Canadians to save more would shift the supply curve
to the right
• If a reform of tax law encourages greater saving, it would result in lower equilibrium
interest rate and wound stimulate investment.
Policy 2: Investment Incentives (Page 179 to 180)
• Investment tax credit – gives a tax advantage to any firm building a new factory or
buying a new piece of equipment
• A reform of the tax laws encouraging greater investment would result in higher interest
rates and greater saving.
Policy 3: Government Budget Deficits and Surpluses (Page 180 to 183)
• Government debt – the sum of all past budget deficits and surpluses
• In the case of a budget deficit o Supply of loanable funds decreases
o Crowding out – a decrease in investment that results from government borrowing
o When the government reduces national saving by running a budget deficit, the
interest rate rises and investment falls
o Government budget deficits reduce the economy’s growth rate
• Increased borrowing by government shifts supply curve, increased borrowing by private
investors demand the supply curve.
o Loanable funds means the flow of resources available to fund private investment.
Thus a government deficit reduces the loanable funds.
• Vicious circle – 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 tax support programs,
and the result can be even higher budget deficits
• In the case of a budget surplus
o Increases the supply of loanable funds, reduces the interest rate and stimulates
o Higher investment = greater capital accumulation and more rapid economic
• Virtuous circle – results when surpluses increase the supply of loanable finds, reduce
interest rates, stimulate investment, and result in faster economic growth; faster growth
leads to higher tax revenue and lower spending on income-tax support programs, and
the result can be even higher budget surpluses. Chapter 9 – Unemployment and its Natural Rate
• Amount of unemployment affects the overall standard of living within countries as well –
people who lose their job will see a drop in their standard of living.
• More employed workers would lead to a higher GDP level
• The problem of unemployment is divided into two categories – long run and short run
o Natural rate of unemployment – the amount of unemployment that the economy
o Cyclical unemployment – the year-to-year fluctuations in unemployment around
its natural rate and is closely associated with the short-run ups and downs of
• ‘Natural does not imply that this rate is constant over time nor does it imply that this rate
is desirable. It just means that this unemployment does not go away on its own even in
the long run.
Identifying Unemployment (Page 192 to 201)
How is unemployment measured? (Page 192 to 195)
• Measured by statistics Canada every month. (part of Labour Force Survey)
• Canada places each adult (aged 15 or older) into one of 3 categories; employed,
unemployed and not in labour force.
o Employed – a person is considered employed if he/she spent some of the
previous week working at a paid job.
o Unemployed – A person is unemployed if he/she is on temporary layoff or is
looking for a job.
o Not in labour force – a person who fits into neither of first two categories (ex: full
time student, homemaker or retiree)
• Labour force is the total number of workers including both the unemployed and the
employed (Number of employed + number of unemployed = Labour Force)
• Unemployment rate – the percentage of the labour force that is unemployed. Computes
rates for entire population and more narrow groups like – young, old, men, women, etc.
Unemploymentrate= Numberof unemployed x100
o Labour Force
• Labour-force participation rate – the percentage of the adult population that is in the
labour force. Tells us the fraction of population that has chosen to participate in the
labour market. This is also calculated for the entire population and for specific groups.
Labour−forceparticipationrate= Labour Force x100
o Adult Population
• Women have lower rates of labour-force participation than men in the same age group.
Young people aged 15 to 25 have much higher rates of unemployment that older people.
• Labour-force data allows economists and policymakers to monitors changes in the
economy over time. The economy always has some unemployment and that the amount changes year to year. Unemployment rate and change vary in different regions of the
Case study – Labour Force participation of Men and Women in the Canadian Economy
• Changes in technology, political-social attitudes and improved birth control in Canada
have led to a changing role for women in Canada. (heavy impact on economy as well)
• After World War 2, the difference between the participation rates of men and women has
• A growing number of women have entered the labour force. Men and women are now
playing a ‘more equal’ role in the economy.
Does the unemployment rate measure what we want it to? (PROBLEMS)(Page 197)
• It is hard to distinguish between a person who is unemployed and a person who is not in
the labour force.
• Because people move into and out of the labour force so often and for a variety of
reasons, statistics on unemployment can be difficult to interpret.
• Some who report being unemployed may not be trying hard to find a job. People may
want to qualify for EI or they are actually working and being paid under the table. In this
case it may be more realistic to view these individuals as out of the labour force or in
some cases employed.
• Some of those who report being out of the labour force may in fact want to work.
o Discouraged searchers – individuals who would like to work but have given up
looking for a job. Such workers do not show up in unemployment statistics even
though they are truly workers without jobs.
o Some workers may be working part time when they want to work full time.
Although these workers are working less than they want to and are
underemployed they do not show up in unemployment statistics.
• Official unemployment rate is a useful but imperfect measure of joblessness.
How long are the unemployed without work (Page 198)
• In 2009 the average spell of unemployment in Canada lasted 15.6 weeks. However, this
average hides a lot of interesting variation.
o The average spell of unemployment varied across the country.
o Averages also hide the fact that there may be a wide dispersion of
unemployment experiences across individuals.
• Therefore policymakers should be careful when interpreting data on unemployment and
when designing policies to help unemployed. Most people will soon find jobs – policy
solutions directed toward fixing the unemployment problem should be directed towards
those suffering prolonged spells of unemployment.
Why are there always some people unemployed (Page 199 to 201)
• In an ideal labour market, wages would adjust to balance the quantity of labour supplied
and the quantity of labour demanded. This would ensure that all workers are always fully
• However in reality there are always workers without jobs even when the economy is
• Natural rate of unemployment – the rate of unemployment to which the economy tends
to return in the long run. In Canada the estimate is currently 6 to 8 percent. • The observed unemployment rate fluctuates around the natural rate.
• Cyclical unemployment – the deviation of unemployment from its natural rate.
o The difference between the observed unemployment rate and the natural
unemployment rate is the cyclical unemployment rate.
• There are 4 ways to explain unemployment in the long run
o IT takes time for workers to search for the jobs that are best suited for them.
Frictional unemployment – results because it takes time for workers to search for
the jobs that best suit their tastes and skills (explains short spells of
o Number of jobs available in some labour markets may be insufficient to give a job
to everybody who wants one. Structural unemployment – results because the
number of jobs available in some labour markets is insufficient to provide a job
for everyone who wants one. (explains longer spells of unemployment)
Results when wages are for some reason set above the level that brings
supply and demand into equilibrium. Three possible reasons for an
above-equilibrium wage: minimum wage laws, unions and efficiency
Job Search (Page 201 to 205)
• One reason why economies always experience some unemployment is job search
• Job search – the process by which workers find appropriate jobs given their tastes and
• Workers differ in their tastes and skills, jobs vary in their attributes
Why some frictional unemployment is inevitable (Page 201 to 202)
• Frictional unemployment is often the result of changes in the demand for labour among
• Ex: when consumers prefer HP over dell computers, HP will increase employment and
dell lays off workers. Results in a period of unemployment.
• Regions of the country produce different goods, therefore employment can rise in one
region while it falls in another.
o Sectorial shifts – changes in the composition of demand among industries or
o Example oil price falling; people lose jobs in Alberta but people can gain jobs in
• Frictional unemployment is inevitable because the economy is always changing.
Workers in declining industries often find themselves out of work and searching for new
Public Policy and Job Search (Page 202 to 203)
• If public policy can reduce the time it takes unemployed workers to find new jobs it can
reduce the economy’s natural rate of unemployment.
• Government programs try to facilitate job search in various ways
o Government run agencies that give out information on job vacancies
o Public training programs to help transition workers from declining to growing
o EI programs • Advocates of government programs believe they make the economy operate more
efficiently by keeping the labour force more fully employed and reduce inequities in a
constantly changing market economy. In certain scenarios such as when a complete
industry gets wiped out, the private sector will be unable to protect workers –
government needs to step in.
• Critics of these programs question whether the government should get involved with the
process of job search. These critics say that government is no better and most likely
worse at disseminating the right information to the right workers and deciding what kinds
of worker training would be most valuable. They claim these decisions are best made
privately by workers and employees.
Employment Insurance (Page 203 to 205)
• Employment insurance – a government program that partially protects workers incomes
when they become unemployed (temporarily provides unemployed workers with income)
• Many economists believe that this causes the unemployment rate to be higher and
increase the amount of frictional unemployment
• Two considerations determine when and how long workers can collect EI benefits; the
number of hours worked in the past year and the unemployment rate in the area of
o In part of country with high unemployment rates, fewer hours of work are needed
to be eligible and it can be collected for a long time
• EI can increase (?) unemployment because people respond to incentives. Unemployed
workers may devote less effort to job search and turn down unattractive job offers.
o Job duration is affected by the length of time required to be eligible to collect EI
benefits. The study found that those who collect EI tend to quit their jobs much