26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM WHAT’S NEW IN THE FIFTH EDITION: There is added clarification on the budget deficit and how it affects the supply of loanable funds. There is also a new In the News feature: “In Praise of Misers.” LEARNING OBJECTIVES: By the end of this chapter, students should understand:  some of the important financial institutions in the U.S. economy.  how the financial system is related to key macroeconomic variables.  the model of the supply and demand for loanable funds in financial markets.  how to use the loanable-funds model to analyze various government policies.  how government budget deficits affect the U.S. economy. CONTEXT AND PURPOSE: Chapter 26 is the second chapter in a four-chapter sequence on the production of output in the long run. In Chapter 25, we found that capital and labor are among the primary determinants of output. For this reason, Chapter 26 addresses the market for saving and investment in capital, and Chapter 27 addresses the tools people and firms use when choosing capital projects in which to invest. Chapter 28 will address the market for labor. The purpose of Chapter 26 is to show how saving and investment are coordinated by the loanable funds market. Within the framework of the loanable funds market, we are able to see the effects of taxes and government deficits on saving, investment, the accumulation of capital, and ultimately, the growth rate of output. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 465 466  Chapter 26/Saving, Investment, and the Financial System KEY POINTS:  The U.S. financial system is made up of many types of financial institutions, such as the bond market, the stock market, banks, and mutual funds. All of these institutions act to direct the resources of households that want to save some of their income into the hands of households and firms who want to borrow.  National income accounting identities reveal some important relationships among macroeconomic variables. In particular, for a closed economy, national saving must equal investment. Financial institutions are the mechanism through which the economy matches one person’s saving with another person’s investment.  The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income and lend it out. The demand for loanable funds comes from households and firms who want to borrow for investment. To analyze how any policy or event affects the interest rate, one must consider how it affects the supply and demand for loanable funds.  National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP. CHAPTER OUTLINE: I. Definition of financial system: the group of institutions in the economy that help to match one person’s saving with another person’s investment. II. Financial Institutions in the U.S. Economy A. Financial Markets 1. Definition of financial markets: financial institutions through which savers can directly provide funds to borrowers. 2. The Bond Market a. Definition of bond: a certificate of indebtedness. b. A bond identifies the date of maturity and the rate of interest that will be paid periodically until the loan matures. c. One important characteristic that determines a bond’s value is its term. The term is the length of time until the bond matures. All else being equal, longterm bonds pay higher rates of interest than short-term bonds. d. Another important characteristic of a bond is its credit risk, which is the probability that the borrower will fail to pay some of the interest or principal. All else being equal, the more risky a bond is, the higher its interest rate. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 26/Saving, Investment, and the Financial System  467 e. A third important characteristic of a bond is its tax treatment. For exam

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