Lecture 5

Saving, Investment & the Financial

System
(Ch:13; P.O.M.E)
ECO 104
Faculty: Asif Chowdhury

 Previously we have seen that productivity

determined economic growth & physical capital
improved productivity. In order to encourage such
investments on physical capital, governments look
to stimulate level of savings. So we can see that
investment depends on saving & there are two
sides to the scenario, the saving side & investment
side. It means some people save & others borrow
from that saving to make investments. So the two
groups can be classified as savers & borrowers.
The system through which the savers & borrowers
are coordinated is known as the financial system.

 Financial System: the group of institutions that help to

match one persons saving to another persons
investment.
Savers lend out fund to the financial system
Borrowers borrow that fund from the financial system.
Financial System is a general classification & is made
up of Financial Institutions.
Financial Institutions in turn is farther classified into
two groups:
o Financial Market
o Financial Intermediary

 Financial Market: financial institutions through which

savers can directly provide funds to borrowers. Such
market includes the Bond market & the Stock market.
Bond: a certificate of indebtedness. Bondholders are
creditors to the company.
Stock: claims to partial ownership in a firm.
Although the end objective of both stocks & bonds is to
raise funds for the issuing company, these two types of
instruments differ in their characteristics. Bond holders
are creditors to the company, whereas stock holders are
partial owners. Hence stock holders have claim on part of
company profit, whereas bondholders have no such
claims.

 Also, payments to the bond holders

have to be made irrespective of the
companys situation, whereas stock
holders receive no payments when
the company is facing crisis.
Through both Stocks & Bonds buyers
of these assets ( savers) provide
funds directly to the issuing company
( borrower.)

 Financial Intermediary: are financial institutions

through which savers indirectly provide funds
to borrowers. Financial Intermediary includes:
o Banks
o Mutual Funds
For investors who cant issue stocks or bonds,
they can borrow the funds from banks. People
deposit savings in bank for earning interest &
borrowers borrow from that fund paying
interest.

 Mutual Funds: an institutions that sells shares

to public
& uses the proceeds to buy a
portfolio of stocks & bonds.
When a Mutual Fund institution buys a portfolio
with the public money ( savers) funds flow
indirectly from the savers to the companies
( borrowers) whose stocks & bonds make up
the mentioned portfolio.
As we have seen both through the banks &
Mutual Funds, savers indirectly provide funds to
borrowers.

Understanding Financial Market Mechanism

through Macroeconomic Perspective:
Starting with the National Income Accounting Identity
for GDP calculation:
Y=C+I+G
o Notice that we omitted the variable NX from the
equation, this is because we are assuming a closed
economy ( economy which doesnt involve in
international trading.)Hence the export & import
variables are not included in this analysis.
o Rewriting:
Y- C -G = I
This is referred to as the totals income available after
adjusting for consumption & government expenditures.

 If we call the L.H.S as the National Savings( denoted by S)

then we can say that:
S=I
This means that total savings in the economy is always equal to
the total investment in the economy.
Expanding the S side & adding the variable T representing
Tax-Transfer Payments;
S= (Y- T- C) + ( T-G)
This shows that National Savings has two components; the
L.H.S gives us the Private Savings & the R.H.S gives us the
Public Savings.
S = Private Savings+ Public Savings.
In Economics the term Investment refers to expenditure on
housing & capital equipment.

A Simple Financial Market

Model:
To understand how a financial market coordinates
saving & investment, we shall look at a simple model.
In this model there is only one financial market, all the
savers comes to the market for depositing their funds,
they form the supply side of the market. All the
borrowers comes to the market for borrowing the funds,
they form the demand side of the market. The goods
in this market is loanable funds & the price in the
market is the rate of interest. Since real rate of interest
is adjusted for inflation, real interest rate is considered
in this market. The real interest rate adjust towards the
equilibrium & brings together the demand for loanable
funds & the supply of loanable funds.

Government Policy Impact on the

Financial Market:
If we go back to the analysis of our previous financial
market model & incorporate the impact of government
policies on this market, we shall see that depending on
the type of polices the government pursues, either the
demand side or the supply side will shift & adjust
towards a new equilibrium.
Government raising level of saving: supply level in the
market rises. New equilibrium is at a lower interest rate
& higher quantity of loanable funds.
Government raising level of investment: demand level
in the market rises. New equilibrium is at a higher
interest rate & higher quantity of loanable funds.

Budget Deficit & Budget

Surplus:
When government runs a budget deficit, it
reduces
national
savings
through
borrowing. This in turn leads to a fall in the
supply level in the financial market, this in
turn raises the interest rate, with higher
interest rate cost of borrowing funds goes
up, so investors borrow less funds & make
less investment. Thus the fall in investment
level due to a government budget deficit is
known as the Crowding Out Effect

 The opposite will occur if the

government experiences a budget
surplus since it will raise the level of
national savings.