Lecture 7 - Saving, Investment and the Financial System

Earlier lectures established that investment is central to long-run economic growth. This lecture explains where investment comes from and how it is coordinated in the economy. The key link is saving, and the institution that connects savers and investors is the financial system.

The core question of the lecture is therefore:

The financial system is the collection of institutions that facilitate the flow of funds from savers to borrowers. Its economic role is allocative rather than productive: it does not create resources, but ensures they are used efficiently.

The system operates through:

By lowering transaction costs, pooling risk, and improving information, the financial system raises the level of productive investment and long-run GDP.

In financial markets, savers provide funds directly to borrowers. In return, savers expect compensation in the form of interest or dividends.

The two most important financial markets are:

These markets differ in the nature of the claims they create and the risks they involve.

Bonds are certificates of indebtedness. When an institution issues a bond, it borrows funds and commits to repay:

Bond yields vary due to:

The upward-sloping yield curve reflects compensation for uncertainty over time.

Stocks represent partial ownership of a firm and therefore a claim on its future profits.

Key features:

Stock indices summarise movements in equity prices and are often interpreted as indicators of future economic conditions.

Rather than lending directly, savers often channel funds through financial intermediaries, which stand between savers and borrowers.

The two main types are:

Intermediaries specialise in screening borrowers, diversifying risk, and monitoring investments.

Banks:

The spread between lending and deposit rates reflects administrative costs, risk, and profit.

Investment funds pool savings from many individuals and invest in diversified portfolios of stocks and bonds.

Their economic value lies in:

However, there is limited evidence that active management systematically outperforms the market after fees.

Recall the national income identity:

In a closed economy, , so:

National saving is defined as:

This identity shows that saving finances investment in the aggregate:

Let denote taxes net of transfers. Then:

Where:

If , the government runs a budget deficit and reduces national saving.

The market for loanable funds explains how saving and investment are coordinated.

Key components:

As the real interest rate rises:

The real interest rate adjusts to equate saving and investment.

At equilibrium:

Policies that encourage saving, such as replacing income tax with a consumption tax, increase the supply of loanable funds.

Economic effects:

However, distributional consequences may arise, as higher-income households tend to save more.

When the government runs a budget deficit, it must borrow by issuing bonds.

This reduces public saving and shifts the supply of loanable funds leftward:

This mechanism is known as crowding out.

Crowding out is the reduction in private investment caused by government borrowing.

It highlights a key macroeconomic trade-off:

These mechanisms form the backbone of later analysis of fiscal and monetary policy.

Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning EMEA.