AP Economics

Mr. Bernstein

Module 22: Saving, Investment and the Financial System

February 25, 2015

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AP EconomicsMr. Bernstein

Saving, Investment and the Financial System• Objectives - Understand each of the following:• The relationship between savings and investment

spending• The purpose of the four principal types of financial assets:

stocks, bonds, loans and bank deposits• How financial intermediaries help investors achieve

diversification and help firms source funding of physical capital

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AP EconomicsMr. Bernstein

The Savings-Investment Spending Identity• Assume a simple economy – no G, no Xn

• Total Income = Total Spending• All money spent winds up in

another’s pocket as income

• Total Income = Consumption + Savings• Total Spending = Consumption + Investment• So C + S = C + I…and S = I

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AP EconomicsMr. Bernstein

The Savings-Investment Spending Identity, cont.• Adding in Government• Budget Balance (BB) = Tax revenue – G – Transfers• BB > 0 is a surplus, BB < 0 is a deficit• Now we have S + BB = I• Notice is BB is a deficit, I must decrease

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AP EconomicsMr. Bernstein

The Savings-Investment Spending Identity, cont.• Adding in Capital Inflows/Outflows• Investors can save in home country or overseas• Capital Inflow (CI) is foreign savings coming into the USA

minus US savings flowing out• Now we have S + BB + CI = I• Notice when CI > 0, I must increase

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AP EconomicsMr. Bernstein

Three Tasks of a Financial System• Reducing Transactions Costs• Making it easier and less costly to engage in borrowing

or other financial transactions

• Reducing Risk• Reducing Financial Risk – ie sharing ownership• Diversification – investing in assets with unrelated risks

• Providing Liquidity• Ease of turning asset into cash• Done via loans, stocks, bonds

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AP EconomicsMr. Bernstein

Key Financial System Terms• Wealth = accumulated savings• Financial Asset = Paper Claim to future income• Loans: Lending agreement between borrower and lender• Bonds: Promise by seller to pay fixed amount of

payments plus all principal on maturity date• Loan-Backed Securities: Pool of loans “securitized”• Stocks: Slices or “shares” of ownership

• Physical Assets• Liabilities