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What is fintech and how is technology

changing financial markets?

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Finance, Saving,
and Investment
26
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Describe the financial markets and financial institutions
and explain their economic functions and benefits.
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

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.
Wealth, also called net worth, is the market value of
what a household or a firm owns minis what it owes.

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Figure 26.1
illustrates the
relationship
between capital
and investment.
On January 1,
2019,Tom’s VR
Gear, Inc. had
computers and
equipment valued
at $30,000.

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© 2021 Pearson
26.1 FINANCIAL INSTITUTIONS AND MARKETS

During 2019, the

value of Tom’s
capital fell by
$20,000,
depreciation.
During 2019,
Tom’s spent
$35,000 on new
machines—gross
investment.

Tom’s net investment was $15,000, so at the end

of 2019,Tom had capital valued at $45,000.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

Saving is the amount of income that is not paid in taxes

or spent on consumption, adds to wealth.
Wealth also increases when the market value of assets
rises—called capital gains.
To make real GDP grow, saving and wealth must be
transformed into investment and capital.
This transformation takes place in the markets for
financial capital and through the activities of financial
institutions.

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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
When Tom’s VR Gear wants funds to buy inventories or
to extend credit to their customers, it might get 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
When Walmart wants to expands its business, it gets
the funds it needs by selling bonds.
Governments do too when they need to finance a
budget deficit by issuing bonds.
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.

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

The term of a bond, called the term to maturity, and the

interest rate on a bond varies with its term to maturity.
The relationship between the term of a bond and the
interest rate is called the yield curve.
Usually, a longer-term bond has a higher interest rate, so
the yield curve slopes upward.
But sometimes, and 2019 was the most recent time,
longer-term bonds have a lower interest rate than shorter-
term bonds and the yield curve becomes inverted.
A riskier bond pays a higher interest rate. Bonds are
graded like students’ tests on a scale from Aaa to Ccc.
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26.1 FINANCIAL INSTITUTIONS AND MARKETS

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 corporations’ stocks are traded.
The New York Stock Exchange, the London Stock
Exchange (in England), the Frankfurt Stock Exchange
(in Germany), and the Tokyo Stock Exchange are all
examples of stock markets.

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

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

● Interest Rates and Bond and Stock Prices

The interest rate on bond or a stock is a percentage of
its price.
So if the price rises, other things remaining the same,
the interest rate falls.
And conversely, if the price falls, other things remaining
the same, the interest rate rises.

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

To see this inverse relationship between an asset price

and interest rate, think about a bond that pays $5 a year
and has a price of $200.
The interest rate on this bond is ($5 ÷ $200)×100, or 2.5
percent.
If the price of the bond fell to $100, the interest rate on
the bond would rise to ($5 ÷ $100)×100, or 5 percent.
This relationship means that an asset price and
interest rate are determined simultaneously—one
implies the other.

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26.1 FINANCIAL INSTITUTIONS AND MARKETS

● The Economic Benefits of Financial Markets and

Institutions
The financial Financial markets and institutions bring
three economic benefits. They enable households,
firms, and governments to markets:
● Invest in capital
● Smooth consumption expenditure
● Trade risk

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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.
As the real interest rate rises, fewer projects are
profitable, so the smaller is the quantity of loanable
funds demanded.
As the real interest rate falls, more projects become
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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© 2021 Pearson
 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 expected profit

● Rises during a business cycle expansion and falls
during a recession;
● Rises when technological change creates
profitable new products;
● Rises as a growing population brings increases
demand; and
● Fluctuates with contagious swings of optimism
and pessimism, called “animal spirits” by Keynes

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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. © 2021 Pearson
© 2021 Pearson
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 by saving that dollar is
forgone.

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 26.2 THE LOANABLE FUNDS MARKET

Figure 26.4 shows

the supply of
loanable funds.

Points A through
E on the curve
correspond to
the rows in the
table.

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© 2021 Pearson
 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 household’s disposable income,
the greater is its saving.
● The greater a household’s wealth (what it owns),
the less it will save.
● The higher a household’s 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 influence on saving other than
the real interest rate 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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© 2021 Pearson
 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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© 2021 Pearson
 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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© 2021 Pearson
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 saving and increases the quantity of
investment and the quantity of loanable funds
demanded.
© 2021 Pearson
 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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© 2021 Pearson
 26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

2. The real interest rate

falls to 4 percent a year.

3. The quantity of private

saving 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 saving.
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 deficit.
With a balanced government
budget, 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. © 2021 Pearson
© 2021 Pearson
 26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

2. The real interest rate

rises to 8 percent a year.

3. Saving and the quantity

of loanable funds
increase to $2.5 trillion.
4. The quantity of loanable
funds demanded and
investment decrease to
$1.5 trillion.

Investment decreases.
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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.
© 2021 Pearson
Fintech is a short name for “financial technology.”
The term was coined around 2005 and covers Internet-
based financial services and customized apps, which
automate transactions.
You use fintech when you make a payment with your
smartphone or Venmo a friend.
Cryptocurrencies are a component of fintech.

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The graph show the
financial institutions’
share of loanable
funds.
The traditional
institutions’ share of
the loanable funds
market has shrunk
since the global
financial crisis.

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Personal Loans
This figure shows
the growth of
personal loans and
fintech's expanding
share.
In 2013, most loans
were traditional bank
loans.
By 2018, 38% of
personal loans were
fintech loans.

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Tech loans are easier
and faster to get than
loans from traditional
financial institutions …
and fintech loans
provide a better deal.
For low and medium
risk borrowers, the
interest rate on fintech
loans is 4 percentage
points below the rate
charged by traditional
lenders.
© 2021 Pearson
Crowdfunding is another fintech service.
This fundraising service seeks to remove obstacles faced
by entrepreneurs embarking on the development of risky
but potentially profitable products.
Kickstarter, Indiegogo, and more than 400 other platforms
have helped raise funds that have financed the pursuit of
a wide range of profitable ideas and the creation of
million-dollar businesses.

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