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What created the global

financial crisis?
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26

Finance, Saving,
and Investment

CHAPTER CHECKLIST

When you have completed your

study of this chapter, you will be able to

1 Describe the financial markets and the key financial

institutions.
2 Explain how borrowing and lending decisions are made
and how these decisions interact in the loanable funds
market.
3 Explain how a government budget surplus or deficit
influences the real interest rate, investment, and saving.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Some Financial Definitions

Physical capital is the tools, instruments, machines,
buildings, and other constructions that have been
produced in the past and that are used to produce
goods and services.

Financial capital is the funds that firms use to buy and

operate physical capital.

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Investment, Capital, Wealth, and Saving

Gross investment is the total amount spent on new

capital goods.

Net investment is the change in the quantity of capital

equals gross investment minus depreciation.

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Figure 26.1
illustrates the
relationship
between capital
and investment.
On January 1,
2012,Toms DVD
Burning, Inc. had
DVD recording
machines valued
at $30,000.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

During 2012, the
value of Toms
machines fell by
$20,000,
depreciation.
During 2012,
Toms spent
$30,000 on new
machinesgross
investment.
Toms net investment was $10,000, so at the end of
2012,Tom had capital valued at $40,000.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Wealth is the value of all the things that a person

owns.

Saving is the amount of income that is not paid in

taxes or spent on consumption goods and services;
saving adds to wealth.

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Markets for Financial Capital

Saving is the source of funds that are used to finance
investment, and these funds are supplied and
demanded by three types of markets:
Loans markets
Bond markets
Stock markets

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Loan Markets
Businesses often want short-term loans to buy
inventories or to extend credit to their customers.
Sometimes they get these funds in the form of a loan
from a bank.
Households often want funds to purchase big-ticket
items, such as automobiles or household furnishings
and appliances.
They get these funds as bank loans, often in the form of
outstanding credit card balances.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Bond Markets

Bond is a promise to pay specified sums of money on

specified dates; it is a debt for the issuer.

The bond market is a financial market in which bonds

issued by firms and governments are traded.

The term of a bond might be long (decades) or short

(just a month or two).
Firms often issue very short-term bonds as a way of
getting paid for their sales before the buyer is able to
pay.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Another type of bond is a mortgage-backed security,
which entitles the holder to the income from a package
of mortgages.
Mortgage-backed securities were at the center of the
storm in the financial markets of 20072008.
Stock Markets

Stock is a certificate of ownership and claim to the

profits that a firm makes.

The stock market is a financial market in which

shares of companies stocks are traded.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Financial Institutions
A financial institution is a firm that operates on both
sides of the markets for financial capital: It borrows in
one market and lends in another.
The key financial institutions are :

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Investment banks
Commercial banks
Government-sponsored mortgage lenders
Pension funds
Insurance companies

26.1 FINANCIAL INSTITUTIONS AND MARKETS

Insolvency and Illiquidity

Net worth is the total market value of what it has lent
minus the market value of what it has borrowed.
If net worth is positive, the institution is solvent and can
remain in business.
But if net worth is negative, the institution is insolvent
and must stop trading.
The owners of an insolvent financial institutionusually
its stockholdersbear the loss when the assets are
sold and debts paid.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

A firm is illiquid if it has made long-term loans with
borrowed funds and is faced with a sudden demand to
repay more of what it has borrowed than its available
cash.
In normal times, a financial institution that is illiquid can
borrow from another institution.
But if all financial institutions are short of cash, the market
for loans among financial institutions dries up.
Insolvency and illiquidity were at the core of the financial
meltdown of 20072008.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Interest Rates and Asset Prices

Stocks, bonds, and loans are collectively called financial
assets.
The interest rate on a financial asset is a percentage of
the price of the asset.
So if the asset price rises, other things remaining the
same, the interest rate falls.
And conversely, if the asset price falls, other things
remaining the same, the interest rate rises.
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26.2 THE LOANABLE FUNDS MARKET

The loanable funds market is the aggregate of the
markets for loans, bonds, and stocks.
In the market for loanable funds there is just one average
interest rate which we refer to as the interest rate.

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26.2 THE LOANABLE FUNDS MARKET

Flows in the Loanable Funds Market

Loanable funds are used for
1. Business investment
2. Government budget deficit
3. International investment or lending
Loanable funds come from
1. Private saving
2. Government budget surplus
3. International borrowing
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26.2 THE LOANABLE FUNDS MARKET

The Demand for 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.
Investment is the major item that influences the demand
side of the market for loanable funds.

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26.2 THE LOANABLE FUNDS MARKET

Investment depends on
1. The real interest rate
2. Expected profit
The real interest rate is the opportunity cost of the funds
used to finance the purchase of capital.
So firms compare the real interest rate with the rate of
profit that they expect to earn on their new capital.

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26.2 THE LOANABLE FUNDS MARKET

Firms invest only when they expect to earn a rate of
profit that exceeds the real interest rate.
The higher the real interest rate, the fewer projects that
are profitable, so the smaller is the quantity of loanable
funds demanded.
The lower the real interest rate, the more projects that
are profitable, so the larger is the quantity of loanable
funds demanded.

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26.2 THE LOANABLE FUNDS MARKET

Demand for Loanable Funds Curve
The demand for loanable funds is the relationship
between the quantity of investment demanded and the
real interest rate, other things remaining the same.
The demand for loanable funds is shown by a demand
for loanable funds schedule or curve.

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26.2 THE LOANABLE FUNDS MARKET

Figure 26.2 shows
the demand for
loanable funds.
Points A through E
on the curve DLF
correspond to the
rows in the table.

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26.2 THE LOANABLE FUNDS MARKET

1. A rise in the real
interest rate
decreases the
quantity of
loanable funds
demanded.
2. A fall in the real
interest rate
increases the
quantity of
loanable funds
demanded.
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26.2 THE LOANABLE FUNDS MARKET

Changes in the Demand for Loanable Funds
When the expected profit changes, the demand for
loanable funds changes.
Other things remaining the same, the greater the
expected profit from new capital, the greater is the
amount of investment and the greater is the demand of
loanable funds.

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26.2 THE LOANABLE FUNDS MARKET

The many influences on expected profit can be
placed in three groups:
Objective influences such as the phase of the
business cycle, technological change, and
population growth
Subjective influences summarized in the phrase
animal spirits
Contagion effects summarized in the phrase
irrational exuberance

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26.2 THE LOANABLE FUNDS MARKET

Figure 26.3 shows:
1. An increase in expected
profit increases
investment and shifts the
demand for loanable
funds curve rightward to
DLF1.
2. A decrease in expected
profit decreases
investment and shifts the
demand for loanable funds
curve leftward to DLF2.
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26.2 THE LOANABLE FUNDS MARKET

The Supply of Loanable Funds

The quantity of loanable funds supplied is the total funds
available from private saving, the government budget
surplus, and international borrowing during a given
period.
Saving is the main item and it depends on
1. The real interest rate
2. Disposable income
3. Wealth
4. Expected future income
5. Default risk
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26.2 THE LOANABLE FUNDS MARKET

Other things remaining the same,
The higher the real interest rate, the greater is the
quantity of saving and the greater is the quantity of
loanable funds supplied.
The lower the real interest rate, the smaller is the
quantity of saving and the smaller is the quantity of
loanable funds supplied.

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26.2 THE LOANABLE FUNDS MARKET

The Supply of Loanable Funds Curve
The supply of loanable funds is the relationship
between the quantity of loanable funds supplied and the
real interest rate when all other influences on lending
plans remain the same.
The real interest rate is the opportunity cost of
consumption expenditure.
A dollar spent is a dollar not saved, so the interest that
could have been earned on that saving is forgone.
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26.2 THE LOANABLE FUNDS MARKET

Figure 26.4 shows
supply of loanable
funds.
Points A through
E on the curve
correspond to the
rows in the table.

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26.2 THE LOANABLE FUNDS MARKET

1. A rise in the real
interest rate
increases the
quantity of
loanable funds
supplied.
2. A fall in the
real interest
rate decreases
the quantity of
loanable funds
supplied.
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26.2 THE LOANABLE FUNDS MARKET

Changes in the Supply of Loanable Funds
The four main factors that influence saving and change
the supply of loanable funds are
1. Disposable income
2. Wealth
3. Expected future income
4. Default risk

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26.2 THE LOANABLE FUNDS MARKET

Disposable income is the income earned minus net
taxes.
Other things remaining the same,
The greater a households disposable income, the
greater is its saving.
The greater a households wealth (what it owns),
the less it will save.
The higher a households expected future income,
the smaller is its saving today.

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26.2 THE LOANABLE FUNDS MARKET

Shifts of the Supply of Loanable Funds Curve
Along the supply of loanable funds curve, all the
influences on saving other than the real interest
rate remain the same.
A change in any of these influences on saving
changes saving and shifts the supply of loanable
funds curve.

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26.2 THE LOANABLE FUNDS MARKET

Figure 26.5 shows a change in
the supply of loanable funds.

1. The supply of loanable

funds curve shifts rightward
from SLF0 to SLF1 if
Disposable income
increases.
Wealth, expected future
income, or default risk
decreases.
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26.2 THE LOANABLE FUNDS MARKET

2. The supply of loanable
funds curve shifts leftward
from SLF0 to SLF2 if
Disposable income
decreases.
Wealth, expected
future income, or
default risk increases.

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26.2 THE LOANABLE FUNDS MARKET

Equilibrium in the
Loanable Funds
Market
Figure 26.6 shows how
the real interest rate is
determined.
DLF is the demand for
loanable funds curve
SLF is the supply of
loanable funds curve
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26.2 THE LOANABLE FUNDS MARKET

1. If the real interest rate is
8 percent a year, the
quantity demanded is less
than the quantity supplied.
There is a surplus of
funds. The real interest
rate falls.
2. If the real interest rate is 4
percent a year, the quantity
demanded exceeds the
quantity supplied. There is a
shortage of funds. The real
interest rate rises.
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26.2 THE LOANABLE FUNDS MARKET

3. When the real interest
rate is 6 percent a year,
the quantity of loanable
funds demanded equals
the quantity supplied.
There is neither a shortage
nor a surplus of funds, and
the real interest rate is at its
equilibrium level.

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26.2 THE LOANABLE FUNDS MARKET

Changes in Demand and Supply

1. If

the demand for

loanable funds
increases, the real
interest rate rises.

2. If the supply of
loanable funds
increases, the real
interest rate falls.

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

A Government Budget Surplus

A government budget surplus increases the supply of
loanable funds.
To find the supply of loanable funds, we must add the
government budget surplus to private saving supply.
An increase in the supply of loanable funds brings a
lower real interest rate, which decreases the quantity
of private funds supplied and increases the quantity of
investment and the quantity of loanable funds
demanded.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

Figure 26.8 shows the effects
of government budget surplus.
With balanced government
budgets, the real interest
rate is 6 percent a year and
the quantity of loanable
funds is $2 trillion a year.
1. A government budget
surplus of $1 trillion is
added to private saving to
determine the supply of
loanable funds curve SLF.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

2. The real interest rate falls
to 4 percent a year.
3. The private supply of funds
decreases to $1.5 trillion.
4. The quantity of loanable
funds demanded and
investment increase to
$2.5 trillion.

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

A Government Budget Deficit

A government budget deficit increases the demand for
loanable funds.
The increase in the demand of loanable funds raises
the real interest rate, which increases the quantity of
private funds supplied.
But the higher interest rate decreases investment and
the quantity of loanable funds demanded by firms to
finance investment.

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

Figure 26.9 shows the effects
of government budget surplus.
With balanced government
budgets, the real interest
rate is 6 percent a year and
the quantity of loanable
funds is $2 trillion a year.
1. A government budget deficit
of $1 trillion is added to the
private demand to
determine the demand for
loanable funds curve DLF.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

2. The real interest rate
rises to 8 percent a year.
3. The supply of loanable
funds increases to $2.5
trillion.
4. The quantity of loanable
funds demanded and
investment decrease to
$1.5 trillion.
Investment is crowded out.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

The tendency for a government budget deficit to raise

the real interest rate and decrease investment is called
the crowding-out effect.

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

The Ricardo-Barro Effect
The proposition that a government budget deficit has no
effect on the real interest rate or investment.
The Ricardo-Barro effect operates if private saving and
the private supply of loanable funds increase to offset
any government budget deficit.
That is, the supply of loanable funds increases by an
amount equal to the government budget deficit and the
interest rate does not change.
Most economists regard this outcome unlikely.
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What Created the Global Financial Crisis?

Events in the market for loanable funds, on both the supply
side and demand side, created the global financial crisis.
An increase in default risk decreased the supply of loanable
funds.
The disappearance of some major Wall Street institutions
and lowered profit expectations decreased the demand for
loanable funds.
These institutions include Bear Stearns, Lehman Brothers,
Fannie Mae and Freddie Mac, Merrill Lynch, and AIG.

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What Created the Global Financial Crisis?

But what caused the increase in default risk and the failure
of so many financial institutions?
Between 2002 and 2005, interest rates were low. There
were plenty of willing borrowers and plenty of willing lenders.
Fuelled by easy loans, home prices rose rapidly.
Lenders bundled their loans into mortgage-backed securities
and sold them to eager buyers around the world.

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What Created the Global Financial Crisis?

Then, in 2006, interest rates began to rise and home prices
began to fall.
People defaulted on mortgages and banks took losses.
Some banks became insolvent.
A downward spiral of lending was under way.

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