Monday

 Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.

PART 9 The Real Economy in the Long Run

Chapter 26 of 36 Saving, Investment, and the Financial System

Section 1 of 25

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Chapter 26 - Saving, Investment, and the Financial System - Topics

Financial Intermediaries

Key Numbers for Stock Watchers

Saving and Investment in the National Income Accounts

The Meaning of Saving and Investment

The Market for Loanable Funds

Supply and Demand for Loanable Funds

Saving Incentives

Investment Incentives

Government Budget Deficits and Surpluses

The History of U.S. Government Debt

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saving and investment

chochiku to toushi

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Grok chapter 26 summary:

This chapter explores how the financial system coordinates saving and investment, linking them to key macroeconomic outcomes like capital accumulation, productivity, and long-run growth.

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The Financial System

The financial system consists of institutions that:

match savers — who supply funds

with borrowers — who demand funds for investment

It channels resources from those with excess income to productive uses, such as building factories or buying equipment.

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Financial markets allow direct flows:

Bond market - debt finance:

Bonds are certificates of indebtedness (loans) specifying repayment (maturity date) and interest.

Bond characteristics include

-term (longer terms usually mean higher risk and interest)

-credit risk (higher risk = higher "junk bond" rates)

-tax treatment (e.g., municipal bonds often tax-exempt).

Stock market - equity finance:

Stocks represent partial ownership in a firm, with returns from dividends and capital gains.

Stock prices reflect expected future profitability.

Indexes, such as the Dow 30, track groups of stocks.

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Financial intermediaries facilitate indirect flows:

⦁ Banks take deposits paying interest to depositors and make loans charging higher interest to borrowers.

Banks create money through the fractional reserve system:

When a bank receives a deposit (e.g. $1,000), it is required to keep only a fraction (for example 10%, in vault + at the Fed) as reserves and can lend out the rest ($900).

Instead of giving the borrower physical cash, the bank simply creates a new checking-account deposit of $900 for the borrower.

This new deposit is spendable money that did not exist before, so the money supply has instantly increased from the original $1,000 to $1,900.

The process continues as the loaned funds are spent and redeposited in other banks, which then lend out most of those deposits as well, multiplying the money supply further.

⦁ Mutual funds:

Pool money from many investors to buy diversified portfolios of stocks and bonds.

Benefits include diversification for small investors and professional management, although low-cost index funds often outperform actively managed ones due to lower fees.

These institutions serve the same purpose: directing savings into investment.

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Saving and Investment in National Income Accounts

In the national income accounts, savings and investment are closely linked.

For the economy as a whole in an economy, total national saving equals total investment.

National saving is the portion of income that is not spent on consumption or government purchases.

It consists of two parts:

-private saving, which is the income households have left after paying taxes and consuming

-public saving, which is the surplus (or deficit) left in the government budget after it collects taxes and pays for its spending

In macroeconomics, the term “investment” specifically refers to the purchase of new capital goods such as factories, equipment, and housing, not the purchase of financial assets.

Thus, all the income that is saved in the economy —by households and the government combined— becomes the funds used to finance investment in the nation’s capital stock.

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The Market for Loanable Funds

The market for loanable funds is a model that shows how the real interest rate adjusts to balance

-the supply of loanable funds — which comes from national saving

-with the demand for loanable funds — which comes from investment

The supply curve for loanable funds slopes upward because a higher real interest rate encourages more saving, increasing the quantity of funds that households and the government make available for lending.

The demand curve for loanable funds slopes downward because a higher real interest rate raises the cost of borrowing, which discourages firms from investing in new factories, equipment, and housing.

At the equilibrium real interest rate, the quantity of loanable funds supplied exactly equals the quantity demanded, so saving equals investment.

Any change in government policy, incentives to save, or investment opportunities that shifts either the supply or demand curve will change the equilibrium real interest rate and the level of investment in the economy.

This supply and demand model explains how financial markets coordinate saving and investment and influence long-run economic growth.

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Policy Applications

The loanable-funds model highlights several important policy effects on saving, investment, and the real interest rate.

-Policies that encourage private saving —such as tax reforms that favor saving over consumption— shift the supply of loanable funds to the right, lowering the real interest rate and raising investment.

-Policies that encourage investment, such as investment tax credits, shift the demand for loanable funds to the right, raising both the real interest rate and the equilibrium quantity of saving and investment.

When the government runs a budget deficit, public saving falls, which reduces national saving and shifts the supply of loanable funds to the left.

This raises the real interest rate and crowds out private investment, leading to a smaller capital stock and slower long-run economic growth.

Summary: When the government runs a budget deficit, it spends more (G) than it collects in taxes (T), so public saving (T – G) becomes negative meaning it falls.

In contrast, government budget surpluses increase national saving, lower interest rates, and boost investment.

Summary: When the government runs a budget surplus, it spends less (G) than it collects in taxes (T), so public saving (T – G) becomes positive meaning it rises.

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The chapter discusses:

-how financial markets efficiently allocate scarce resources —saved and loanable money

-government policies affecting saving and investment

It assumes a closed (domestic only) economy for simplicity in the core model while noting complications in open (international) economies.

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Why does a company borrow money when it can sell shares in the stock market to raise money?

Companies borrow money (through bonds or bank loans) rather than selling shares because debt allows them to raise funds without giving up ownership or control of the company.

When a firm issues new stock, it sells partial ownership to outsiders, who then share in future profits through dividends and gain voting rights, reducing the company’s original owners’ earnings.

Borrowing creates a fixed obligation to repay the principal plus interest, but once the loan is repaid, the lenders have no further claim on the firm’s profits or decision-making.

Additionally, interest payments on debt are tax-deductible, making debt cheaper than equity on an after-tax basis, and successful companies prefer debt to keep the upside gains for themselves rather than sharing them forever with new shareholders.

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Why not always borrow rather than sell shares?

Companies do not always borrow rather than sell shares because excessive debt increases financial risk and can lead to bankruptcy.

Borrowing requires regular interest payments and eventual repayment of principal regardless of how well the business performs.

Dividends to shareholders typically are not demanded and paid out until the company becomes profitable, which can be many years later.

With loans, if profits fall or cash flow weakens, the firm may be unable to make scheduled required interest payments, triggering default, legal action by creditors, or even bankruptcy.

Most firms maintain a balanced mix of debt (loans) and equity (sale of shares) to gain the benefits of cheaper debt financing while avoiding the dangers of too much debt.