Saving-Investment Spending Identity

  • Saving-investment spending identity

    • Fact of accounting is that they are always equal for the economy as a whole
  • Imagine a country with no government and no trade

    • Y = C + I

    • Total Income = Total Spending

    • Total Income = Consumer spending + Savings

    • Total spending = Consumer spending + investment spending

    • Therefore Savings = Investment spending

Budget Surplus and Deficit

  • Sometimes, the government will "save" money and in other years, it will spend more than its revenue collected in taxes

  • Budget surplus

    • occurs when government revenue exceeds government spending
  • Budget deficit

    • occurs when government spending exceeds government revenue
  • Budget balance

    • difference between government spending and revenue (either deficit or surplus)
  • National savings

    • private savings + budget balance

Capital Inflows and Outflows

  • Countries receive inflows of funds and also generate outflows of funds

  • Capital inflow

    • net inflow of funds into the country


  • In 2008, the United States had capital inflows totaling $707 billion, meaning the US is an attractive place to save money

    • Total investment spending = $ 2,632 billion

    • Private savings = $2,506.9 billion

    • Budget deficit = $683 billion

    • Capital inflows = $707 billion

    • National Savings = Private Saving - Budget Deficit

    • National Savings + Capital Inflow = $2,530.9

    • Statistical discrepancy = Investment - Savings = $101.1 billion

Tasks of a Financial System

  • Reduce Transaction Costs

    • Companies will get loans from banks or issue bonds to raise money

    • To get a comparable amount form individuals would be logistically difficult if not impossible

  • Reduce Risk

    • People have various levels of risk tolerance, so financial systems reduce risk through diversification

    • Sole ownership of a $1 billion company would be risky

  • Provide Liquidity

    • Having access to cash is critical

    • Liquid assets are generally preferred to illiquid assets

Types of Financial Assets


  • Bonds

    • An IOU issued by the borrower with the seller of the bond paying a fixed yearly interest and principal at the end of the term of the loan

    • The higher the default risk, the higher the interest rate

  • Loan-backed securities

    • Loans that are packaged together & sold as assets

    • Financial crisis of 2008, in part, because high rate of mortgage-backed securities defaulted

  • Stocks

    • Direct ownership in a company

    • Owning one share of Apple (AAPL) means you own 1/900,000,000 of the company

Financial Intermediary


  • Institutions that transforms funds gathered from many individuals into financial assets

    • Mutual Funds

    • Pension Funds

    • Life Insurance Companies

    • Banks

  • About 75% of wealth in the United States is held through these four types of financial intermediaries rather than directly through cash

  • Mutual Funds

    • Financial intermediary that creates a portfolio of stocks and/or bonds and then sells shares to individual investors

    • Major benefit includes diversification of investments rather than owing one single stock

    • Major downside would be the inability to hit a "homerun" with one single stock

    • In the United States, households own over $10 trillion in mutual funds

    • Fidelity Investments (2013) had ~$1.8 trillion in assets under management

  • Pension Funds

    • Pension funds are mutual funds that hold assets for its members to provide retirement income

    • Two of the largest pension funds in the United States are CalSTRS and CalPERS

    • California teachers opt out of Social Security (6.2%) and pay into CalSTRS (8%)

  • Life Insurance Companies

    • Life insurance companies take in premiums from policyholders and make payments to beneficiaries upon death of insured

    • Term, ROP Term, Universal, Whole

    • Life insurance companies pool together individual premiums, make various investments and do their best to avoid making payouts

  • Banks

    • Banks accept funds from depositors

    • Banks keep only a fraction of a customers' deposits in the form of cash

      • Most deposits are lent out to businesses, home buyer and other borrowers

      • Banks lends for long period of times but subject to the condition that its depositors could demand funds at any time

    • The Federal Deposit Insurance Corporation (FDIC) insures up to $250,000 for each account

Practice Questions

  • Reducing which of the following is a task of the financial system

    a. Transaction costs

    b. Risk

    c. Liquidity

    Answer: a & b

  • Which of the following is NOT a type of financial asset

    a. Loan-Backed Securities

    b. Bonds

    c. Bank Deposits

    d. Stocks

    e. Car

    Answer: e

  • The federal government is considered to be "saving" money when

    a. There is a budget deficit

    b. There is a budget surplus

    c. There is no budget surplus or deficit

    d. Saving does not equal investment spending

    e. National savings equals private savings

    Answer: b

  • A nonprofit institution collects the saving of its members and invest those funds in a variety of assets so that it can provide retirement income to its members is called which of the following?

    a. Mutual Fund

    b. Life Insurance Company

    c. Pension Fund

    d. Credit Union

    e. Bank

    Answer: c

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