1. MODULE 22
SAVING, INVESTMENT, AND THE
FINANCIAL SYSTEM

2. INTRODUCTION
Two instrumental sources of economic growth are:
1. Improvements in human capital (through increasing the
skills and knowledge of the people in the workforce)
2. Increases in physical capital (goods used to make other
goods)
Private investment spending is mostly done with other people’s
money.
1. They may raise this money by selling their company’s stock
2. Or they may raise this money by borrowing from financial
institutions
If they borrow money to create physical capital, they are
charged an interest rate.

3. THE INTEREST RATE
 The interest rate is the price, calculated as a percentage of
the amount borrowed, charged by lenders to borrowers for
the use of their savings for one year.

4. THE SAVING-INVESTMENT SPENDING
IDENTITY
 The most important idea to remember about savings and
investment is that they are always equal
 This is a fact of accounting called the savings-investment
spending identity:
Total income = Total spending
Total income = Consumer spending + Savings
Total spending = Consumer spending + Investment
spending
Consumer spending + Savings = Consumer spending +
Investment spending
Savings = Investment spending

5. THE BUDGET BALANCE
 This simplified economy changes in two ways when government
and the rest of the world enter the picture. The first case:
 Government, as well as households, can save if it collects more
tax revenue than it spends. When this happens, the difference is
called a budget surplus (and is equivalent to savings by
government).
 If the difference is negative, because government spending is
greater than tax revenue, this is called a budget deficit (and is
equivalent to dissaving by government).
 The term budget balance refers to both cases, being positive (a
budget surplus) or negative (a budget deficit).
 National savings is equal to the sum of private savings and the
budget balance, while private savings is disposable income minus
consumption.

6. THE CAPITAL INFLOW
 Second, because any one country is part of a wider world
economy, savings are not necessarily spent on physical capital
located in the same country in which the savings are generated
(savings of people who live in any one country can be used to
finance investment spending in other countries).
 Any given country can receive inflows of funds (foreign savings
that finance investment spending in that country), and any given
country can generate outflows of funds (domestic savings that
finance investment spending in another country).
 The net effect of international inflows and outflows of funds on the
total savings available for investment spending is known as the
capital inflow into that country, and can be positive or negative:
Capital inflow = Total inflow of foreign funds – Total outflow of
domestic funds to other countries

7. THE CAPITAL INFLOW
 From a national perspective, a dollar generated by national
savings and a dollar generated by capital inflow are not
equivalent.
 Borrowed money must be repaid with interest.
 If the money comes from national savings, the interest is
repaid with interest to someone domestically.
 If the money comes from capital inflow, it must be repaid with
interest to a foreigner.
 Therefore, a dollar of investment spending financed by
capital inflow comes at a higher national cost (the interest
that must eventually be paid to a foreigner), than a dollar
borrowed from national savings.

8. THE CAPITAL INFLOW
 The application of the savings-investment spending identity
to an economy open to inflows or outflows of capital means
that investment spending is equal to savings, where savings
is equal to national savings plus capital inflow.
 In an economy with a positive capital inflow, some
investment spending is funded by the savings of foreigners.
 In an economy with a negative capital inflow (a net outflow),
some portion of national savings is funding investment
spending in other countries.

9. THE FINANCIAL SYSTEM
 Financial markets are where households invest their current
savings and their accumulated savings, or wealth, by
purchasing financial assets.
 A financial asset is a paper claim that entitles the buyer to
future income from the seller.
 A household can also invest its current savings or wealth by
purchasing a physical asset, which is a claim on a tangible
object (such as a house or piece of equipment), which it can
then dispose of as he or she wishes, such as rent it or sell it.
 A loan is an important financial asset in the real world; it is
owned by the lender.
 When a loan is made, a liability is created. A liability is a
requirement to pay money in the future.

10. THREE TASKS OF A FINANCIAL SYSTEM
 The three tasks of a financial system are to reduce the
problems facing borrowers and lenders:
1. Transaction costs
2. Risk
3. Desire for liquidity
 In reducing these problems in a cost-effective way, they
enhance the efficiency of financial markets, so that lenders
and borrowers make mutually beneficial trades, which make
society as a whole richer.

11. REDUCING TRANSACTION COSTS
 Transaction costs are the expenses of putting together and
executing a deal.
 When a large business wants to borrow money, they can
either get a loan from a bank or sell bonds in the bond
market.
 Getting a loan from a bank avoids large transaction costs
because there is only one borrower and one lender.
 The principal reason there is a bond market is that it allows
companies to borrow large sums of money without incurring
in large transaction costs.

12. THE FINANCIAL SYSTEM
 In addition to loans, other types of financial assets include
stocks, bonds, and bank deposits.
 A financial asset is a claim to future income that someone
has to pay, and it also becomes someone else s liability.
 A well functioning financial system is critical in achieving
long-run growth because it encourages greater savings and
investment spending. It also ensures that savings and
investment spending are undertaken efficiently.

13. REDUCING RISK
 Financial risk is uncertainty about future outcomes that
involve financial losses or gains.
 Financial risk is a problem because the future is uncertain; it
holds the potential for losses as well as gains.
 A well-functioning financial system helps people reduce their
exposure to risk, by allowing them to engage in
diversification.
 Diversification is done by investing in several assets with
unrelated, or independent, risks. This lowers the total risk of
loss.
 The desire of individuals to reduce their total risk by
engaging in diversification is why there are stocks and a
stock market.

14. PROVIDING LIQUIDITY
 The third task of the financial system is to provide investors
with liquidity, which is important because the future is
uncertain.
 An asset is said to be liquid if it can quickly be converted
into cash without much loss of value. If it cannot, then it is
said to be illiquid.
 Stocks and bonds are a partial answer to the problem of
liquidity.
 Banks provide a further way for individuals to hold liquid
assets and still finance illiquid investments.

15. TYPES OF FINANCIAL ASSETS
 There are four main types of financial assets:
1. Loans
2. Bonds
3. Stocks
4. Bank deposits
 Additionally, financial innovation has allowed the creation of
a wide range of loan-backed securities.

16. LOANS
 A loan is a lending agreement between an individual lender
and an individual borrower.
 Most people and small businesses encounter loans in the
form of bank loans.
 Advantage of loans: A given loan is usually tailored to the
needs of the borrower and his ability to repay.
 Disadvantage of loans: Making a loan to an individual
person or a business typically involves a lot of transaction
costs (such as the cost of negotiating the terms of the loan,
checking the borrower s credit history and ability to repay)
 To minimize these costs, corporations or governments often
sell (issue) bonds to borrow money.

17. BONDS
 A bond is an IOU issued by the borrower. The seller of the
bond promises to pay fixed amount of interest each year
and to repay the principal (the value stated on the face of the
bond) to the owner of the bond on a particular date.
 A bond is a financial asset from its owner s point of view and
a liability from the issuers s point of view.
 A bond issuer sells a number of bonds with a given interest
rate and maturity date to whoever is willing to buy them.

18. BONDS
 Bond purchasers can acquire information (free of charge) on
the quality of the bond issuer from bond rating
agencies, instead of having to investigate for themselves.
 A concern for investors is the possibility of a default (the risk
that the bond issuer might fail to make payments as specified
by the bond contract.
 Once the bond s risk of default has been rated, it can be sold
on the bond market as a more or less standardized product
(with clearly defined terms and quality).
 In general, bonds with a higher default risk must pay a higher
interest rate to attract investors.

19. BONDS
 Another important advantage of bonds is that they are easy
to resell, which provides liquidity to bond purchasers.
 A bond may pass through many hands before it comes due,
while loans are much more difficult to resell because they are
not standardized (they may differ in size, quality, terms, etc.)
 So loans are a lot less liquid than bonds.

20. LOAN-BACKED SECURITIES
 Loan-backed securities are assets created by pooling
individual loans and selling shares in that pool (a process
called securitization).
 Mortgage-backed securities are the best-known example, but
has also been widely applied to student loans, crediti card
loans, and auto loans.
 These loan-backed securities trade on financial markets like
bonds and may be preferred by investors because they
provide more diversificaion and liquidity than individual loans.
 However, with so many loans packaged together, it can be
difficult to assess the true quality of the asset.
 With the bursting of the housing bubble in 2007-2008,
widespread defaults on mortgages led to large losses for
holders of mortgage-backed securities.

21. STOCKS
 A stock is a share in the ownership of a company.
 A share of stock is a financial asset from its owner s point of
view and a liability from the company s point of view.
 Although not all companies sell shares of their stock
(“privately held” companies are owned by an individual or by
few partners, who get to keep all of the company s profit).
 However, most large companies do sell stock.
 Companies sell stock because of risk: few individuals are
risk-tolerant enough to face the risk involved in being the
sole owner of a large company.

22. STOCKS
 However, reducing the risk that business owner s face is not
the only way that stocks improve a society s welfare; they
also improve the welfare of investors who buy stocks
(shareowners or shareholders).
 Shareholders are able to enjoy the higher returns over time
that stocks generally offer in comparison to bonds
(historically, stocks have yielded about 7% after adjusting to
inflation, and bonds have yielded only about 2%)

23. STOCKS
 However, owning stocks is riskier than owning bonds,
because legally, a company must pay what it owes its
lenders (bondholders), before it distributes any profit to
shareholders.
 If a company should fail (be unable to pay its obligations and
file for bankrupcy) its physical and financial assets go to the
bondholders (its lenders), while its shareholders typically
receive nothing.
 Although a stock generally proveds a higher return to an
investor than a bond, it also carries a higher risk.

24. FINANCIAL INTERMEDIARIES
 The financial system has devised ways to help investors as
well as business owners simultaneously manage risk and
enjoy somewhat higher returns through the services of
institutions known as financial intermediaries.
 A financial intermediary is an institution that transforms funds
gathered by many individuals into financial assets.
 The most important types of financial intermediaries are:
1. Mutual funds
2. Pension funds
3. Life insurance companies
4. Banks

25. MUTUAL FUNDS
 Stock investors can lower their total risk by diversifying. By
owning a diversified portfolio of stocks (a group of stocks in
which risks are unrelated, or offset, one another), rather than
concentrating investment in the shares of a single company
or group of related companies.
 Financial advisers almost always advise to diversify not only
their stock portfolio, but their entire weath by holding other
assets in addition to stock: bonds, real estate, and cash
(and plenty of insurance in case of accidental losses!)
 Diversified stock portfolios can incur in high transaction costs
(mostly fees paid to stockbrokers) because they are buying a
few shares of a lot of companies.

26. MUTUAL FUNDS
 A mutual fund is a financial intermediary that creates a
stock portfolio by buying and holding shares in companies
and then selling shares of the stock portfolio to individual
investors.
 This allows investors can indirectly hold a diversified
portfolio, achieving a higher return for any given level of risk
without incurring in high transaction costs.

27. PENSION FUNDS AND
LIFE INSURANCE COMPANIES
 Pension funds are non-profit institutions that collect the
savings of their members and invest those funds in a wide
variety of assets, providing their members with income when
they retire.
 They invest in a diverse array of financial assets, allowing
their members to achieve more cost-effective diversifications
and conduct more market research than they would be able
to do individually.
 Life insurance companies guarantee a payment to the
policyholder s beneficiaries when the policyholder dies. By
enabling policyholders to protect their beneficiaries from
financial hardship arising from death, life insurance
companies also improve welfare by reducing risk.

28. BANKS
 A keeps only a fraction of its customers deposits in the form
of ready cash.
 Most of the deposits are lent out to businesses, buyers of
new homes, and other borrowers.
 A bank enables those who want to borrow for long lengths of
time to use the funds of those who wish to lend but
simulaneously want to maintain the ability to get their case
back on demand.
 A bank is a financial intermediary that provides liquid
financial assets in the form of deposits to lenders and used
their funds to finance the illiquid investment spending needs
of its borrowers.

29. BANKS
 A bank is an institution that helps resolve the conflict
between lenders need for liquidity and the financing needs of
borrowers who don t want to use the stock or bond markets.
 A bank works by accepting funds from depositors: when
they put their money in a bank, they are becoming lenders by
lending the bank their money.
 In return, they receive credit for a bank deposit: a claim on
the bank, which is obliged to give you your cash if and when
you demand it.
 A bank deposit is a financial asset owned by the depositor
and a liability to the bank that holds it.

30. BANKS
 How can a bank lend for long periods of time but also be
subject to the condition that its depositors can demand their
funds back at any time?
 The bank counts on the fact that on the average, only a small
fraction of its depositors will want their cash at the same
tiem.
 On any given day, some people will make withdrawals while
others will make deposits; this will roughly cancel each other
out.

31. BANKS
 So the bank only needs to keep a limited amount of cash on
hand to satisfy its depositors.
 If a bank were to become financially incapable of paying its
depositors, individual bank deposits are currently guaranteed
to depositors up to $250,000 by the FDIC (Federal
Depositary Insurance Corporation), which is a federal
agency.
 This reduces the risk to a depositor of holding a bank
deposit, while reducing the incentive to withdraw funds if
concerns about the financial state of the bank should arise.
 Banks play a key economic role by reconciling the needs of
savers for liquid assets with the needs of borrowers for long-
term financing.