Chapter 32
Chapter 23
Finance, Saving, and Investment Financial Institutions and Financial Markets • •
Saving is the source of funds that are used to finance investment. Financing investment is crucial because investment in new capital makes the economy grow.
•
These funds are supplied and demanded in three types of markets: loan markets, bond markets, and stock markets.
•
Physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used today to produce goods and services. The funds that firms use to buy physical capital are called financial capital.
•
A financial institution is a firm that operates on both sides of the market for financial capital.
•
The key Canadian financial institutions are banks, trust and loan companies, credit unions and caisses populaires, pension funds, and insurance companies.
The Market for Loanable Funds •
How investment is financed: o Y = C + S + T (households use their income to buy consumption goods, save, and pay taxes) o Y = C + I + G + NX o So, S + T = I + G + NX o And, I = S + T - G - NX o S is household (private) saving o T - G is government saving (or dissaving) o -NX is foreign saving o The sum of private saving (S) and government saving (NT – G) is called national saving.
•
The nominal interest rate is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.
• •
• •
• •
The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period. The figure below shows the demand for loanable funds curve. • Other things remaining the same, the higher the real interest rate, the smaller is the quantity of loanable funds demanded; and the lower the real interest rate, the greater is the quantity of loanable funds demanded. • When expected profit from new capital increases during an expansion, the greater is the amount of investment and the greater the demand for loanable funds. The demand for loanable funds curve shifts rightward.
The quantity of loanable funds supplied is the total funds available from private saving, a government budget surplus, and international borrowing during a given period. The figure below shows the supply of loanable funds curve. •
•
Other things remaining the same, the higher the real interest rate, the greater is the quantity of loanable funds supplied; and the lower the real interest rate, the smaller is the quantity of loanable funds supplied. The supply of loanable funds increases and the supply of loanable funds curve shifts rightward when a household’s disposable income increases, expected future income decreases, wealth decreases, and default risk decreases.
•
The figure below shows equilibrium in the market for loanable funds. • A surplus of funds lowers the real interest rate and a shortage of funds raises the real interest rate.
•
The figure to the right shows that an increase in the demand for loanable funds with no change in supply raises the real interest rate and increases the equilibrium quantity of loanable funds. The bottom figure shows that an increase in the supply of loanable funds with no change in demand lowers the real interest rate and increases the equilibrium quantity of loanable funds.
•
Government in th e Market for Loanable Funds he • • •
•
•
•
•
•
The figure to the left shows the market for loanable funds when the government has a budget surplus of $100 billion. The government budget surplus is added to private saving (PSLF) to determine the supply of loanable funds (SLF). A government budget surplus lowers the real interest rate and increases the quantity of loanable funds.
The figure to the right shows the market for loanable funds when the government has a budget deficit of $100 billion. The government budget deficit is added to private demand for loanable funds (PDLF) to determine the demand for loanable funds (DLF). A government budget deficit raises the real interest rate, increases the quantity of loanable funds and decreases investment. The tendency for a government budget deficit to raise the interest rate and decrease investment is called the crowding-out effect. In contrast, the Ricardo-Barro effect holds that neither a government budget surplus nor a government budget deficit have any effect on the real interest rate or investment.
The Global Market for Loanable Funds
• • • • •
• •
•
The left graph shows the demand for loanable funds and the supply of loanable funds in the global loanable funds market. The world equilibrium real interest rate is 5 percent. The middle graph shows the situation of a country that if isolated from the global market has a real interest rate of 6 percent, and a shortage of loanable funds at the world real interest rate. Funds flood into this country, and the country faces the supply of loanable funds curve, SLF, which is horizontal at the world equilibrium real interest rate. The equilibrium quantity of loanable funds occurs at the intersection of the SLF and the DLF curves. The right graph shows the situation of a country that if isolated from the global market has a real interest rate of 4 percent, and a surplus of loanable funds at the world real interest rate. This country is an international lender. Funds flow quickly out of this country to seek the higher return in other countries. The country faces the supply of loanable funds curve, SLF, which is horizontal at the world equilibrium real interest rate. The equilibrium quantity of loanable funds occurs at the intersection of the SLF and the DLF curves.
Finance, Saving, and Investment Financial Institutions and Financial Markets • •
Saving is the source of funds that are used to finance investment. Financing investment is crucial because investment in new capital makes the economy grow.
•
These funds are supplied and demanded in three types of markets: loan markets, bond markets, and stock markets.
•
Physical capital is the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used today to produce goods and services. The funds that firms use to buy physical capital are called financial capital.
•
A financial institution is a firm that operates on both sides of the market for financial capital.
•
The key Canadian financial institutions are banks, trust and loan companies, credit unions and caisses populaires, pension funds, and insurance companies.
The Market for Loanable Funds •
How investment is financed: o Y = C + S + T (households use their income to buy consumption goods, save, and pay taxes) o Y = C + I + G + NX o So, S + T = I + G + NX o And, I = S + T - G - NX o S is household (private) saving o T - G is government saving (or dissaving) o -NX is foreign saving o The sum of private saving (S) and government saving (NT – G) is called national saving.
•
The nominal interest rate is the number of dollars that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.
• •
• •
• •
The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given period. The figure below shows the demand for loanable funds curve. • Other things remaining the same, the higher the real interest rate, the smaller is the quantity of loanable funds demanded; and the lower the real interest rate, the greater is the quantity of loanable funds demanded. • When expected profit from new capital increases during an expansion, the greater is the amount of investment and the greater the demand for loanable funds. The demand for loanable funds curve shifts rightward.
The quantity of loanable funds supplied is the total funds available from private saving, a government budget surplus, and international borrowing during a given period. The figure below shows the supply of loanable funds curve. •
•
Other things remaining the same, the higher the real interest rate, the greater is the quantity of loanable funds supplied; and the lower the real interest rate, the smaller is the quantity of loanable funds supplied. The supply of loanable funds increases and the supply of loanable funds curve shifts rightward when a household’s disposable income increases, expected future income decreases, wealth decreases, and default risk decreases.
•
The figure below shows equilibrium in the market for loanable funds. • A surplus of funds lowers the real interest rate and a shortage of funds raises the real interest rate.
•
The figure to the right shows that an increase in the demand for loanable funds with no change in supply raises the real interest rate and increases the equilibrium quantity of loanable funds. The bottom figure shows that an increase in the supply of loanable funds with no change in demand lowers the real interest rate and increases the equilibrium quantity of loanable funds.
•
Government in th e Market for Loanable Funds he • • •
•
•
•
•
•
The figure to the left shows the market for loanable funds when the government has a budget surplus of $100 billion. The government budget surplus is added to private saving (PSLF) to determine the supply of loanable funds (SLF). A government budget surplus lowers the real interest rate and increases the quantity of loanable funds.
The figure to the right shows the market for loanable funds when the government has a budget deficit of $100 billion. The government budget deficit is added to private demand for loanable funds (PDLF) to determine the demand for loanable funds (DLF). A government budget deficit raises the real interest rate, increases the quantity of loanable funds and decreases investment. The tendency for a government budget deficit to raise the interest rate and decrease investment is called the crowding-out effect. In contrast, the Ricardo-Barro effect holds that neither a government budget surplus nor a government budget deficit have any effect on the real interest rate or investment.
The Global Market for Loanable Funds
• • • • •
• •
•
The left graph shows the demand for loanable funds and the supply of loanable funds in the global loanable funds market. The world equilibrium real interest rate is 5 percent. The middle graph shows the situation of a country that if isolated from the global market has a real interest rate of 6 percent, and a shortage of loanable funds at the world real interest rate. Funds flood into this country, and the country faces the supply of loanable funds curve, SLF, which is horizontal at the world equilibrium real interest rate. The equilibrium quantity of loanable funds occurs at the intersection of the SLF and the DLF curves. The right graph shows the situation of a country that if isolated from the global market has a real interest rate of 4 percent, and a surplus of loanable funds at the world real interest rate. This country is an international lender. Funds flow quickly out of this country to seek the higher return in other countries. The country faces the supply of loanable funds curve, SLF, which is horizontal at the world equilibrium real interest rate. The equilibrium quantity of loanable funds occurs at the intersection of the SLF and the DLF curves.
