Investment, Savings, and Financial Markets

• Investment equals private saving plus the government surplus, plus borrowing from other countries S + (T-G) + (M-X) = I
  • S represents private saving
  • T-G represents public saving
  • M-X represents borrowing from other countries
• Investment requires funds
  • Private saving serves as one source of funding.
  • Public surplus (T-G) is another source of funding
    • If T is greater than G, there is a surplus
  • Borrowing from the rest of the world
    • It is a source of funds when there aren't any other savings.
• Income is equal to consumption plus government expenditure plus savings: Income = C+G+S
• Private saving equals income minus consumption minus taxes: priv. Saving = Y-C-T
• Total income equals consumption + government expenditure + investment + net exports: Total income = C+G+I+X-M

Financial Institutions and Financial Markets

• Economics of these distinguish between finance and money, physical capital and financial capital
• Study of finance: how households and firms obtain and use financial resources, coping with risks.
• Study of money: how households and firms use, hold, and manage money, and how it affects the economy.
• Physical capital includes tools, instruments, machines, buildings, and other items produced and used to produce goods and services.
• Financial capital refers to the funds firms use to buy physical capital.

Capital and Investment

• Gross investment refers to the total spending on new capital and the replacement of depreciated assets.
• Depreciation is the reduction in capital value due to wear, tear, and obsolescence.
• Net investment represents the change in the quantity of capital
  • Net investment = Gross investment – Depreciation

Wealth and Saving

• Wealth is the value of all possessions owned by people.
• Saving is the portion of income not used for taxes, consumption goods, or services
• Saving increases wealth, which also arises from rising asset market values, termed capital gains, and decreases from falling values, termed capital losses.
• Saving is the source of funds used to finance investment
  • These funds are active in loan, bond, and stock markets
• Banks provide loans to firms and households in return for interest rate payments.
• Bonds are loans from investors directly to companies and governments, representing a promise to make specified payments.
• A stock is a certificate of ownership and claim to the firm's profits.
• A financial institution operates on both sides of the financial capital market, acting as both borrower and lender, such as:
  • Commercial banks.
  • Government-sponsored mortgage lenders.
  • Pension funds.
  • Insurance companies.

The Loanable Funds Market

• The market for loanable funds includes all individual financial markets (Bond, Stock, and Loan Market).
• Funds that finance investment come from household saving (S), Government budget surplus (T – G), and Borrowing from the rest of the world(M – X).
• The nominal interest rate represents the number of dollars a borrower pays and a lender receives in interest annually, expressed as a percentage of the borrowed amount.

Real Interest Rate

• This adjusts the nominal interest rate to remove the effects of inflation on purchasing power
• The real interest rate equals the nominal interest rate minus the inflation rate.

The Demand for Loanable Funds

• Business investment is the main driver of demand
• Quantity of loanable funds demanded is the total funds for investments
• Demand for investments depends on the real interest rate and predicted profits.
• Demand for loanable funds illustrates the relation between quantity demanded and the real interest rate, when other factors remain constant
• Economic Changes: When expected profit increases, so does the demand for loanable funds

The Supply of Loanable Funds

• The quantity of loanable funds supplied hinges on the real interest rate, disposable income, expected future income, wealth, and default risk.
• Disposable income factors into supply
  • Lower taxes lead to higher disposable income and increased loanable funds.
• Expected future income impacts supply
  • Increased expectation of future income reduces the supply of loanable funds.
• Wealth is a factor
  • Increased wealth reduces the supply.
• Default risk sways supply
  • Higher default risk increases the supply.
• The supply of loanable funds illustrates the relationship between quantity supplied and the real interest rate, assuming other conditions are unchanged.
• Savings is the main component of the supply of loanable funds
• Changes in disposable income, anticipated future earnings, wealth, or default risk alter the supply of loanable funds.
  • For example, increased disposable income, or lower risk all increase loanable funds.

Equilibrium in the Loanable Funds Market

• A state where the real interest rate balances the quantity of loanable funds demanded with the quantity supplied.
• These financial markets are often volatile in the short term, and fluctuations in demand and supply of loanable funds cause volatility
  • These fluctuations result in changing interest rates as well as the amounts lent and borrowed.
  • Which additionally brings fluctuations in asset prices.
• An increase in demand for loanable funds occurs when expected profit increases, which raises real interest rate.
• An increase in the supply of loanable funds shifts the supply curve to the right, lowering the real interest rate and spurring investment.

Government in the Loanable Funds Market

• Government influences the loanable funds when it’s running on a budget surplus or deficit
  • A budget surplus increases the supply of funds
    • Which lowers the real interest rate, reduces private saving, and increases investment.
  • A budget deficit increases the demand for such funds, raising real interest rates
    • This increases private saving and decreases investment.