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This chapter examines how the financial system works. First, we discuss the large variety of institutions that make up the financial system in our economy. Second, we discuss the relationship between the financial system and some key macroeconomic variables notably saving and investment. Third, we develop a model of the supply and demand for funds in financial markets.
et Deficits and Surpluses Abudgetsurplusincreasesthesupplyof loanablefunds,reducestheinterestrate,and stimulatesinvestment Copyright â 2004 South-Western Figure The U.S Government Debt Percent of GDP 120 World War II 100 80 60 Revolutionary War 40 Civil War World War I 20 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 Copyrightâ2004 South-Western Summary TheU.S.financialsystemismadeupof financialinstitutionssuchasthebondmarket, thestockmarket,banks,andmutualfunds Alltheseinstitutionsacttodirecttheresources ofhouseholdswhowanttosavesomeoftheir incomeintothehandsofhouseholdsandfirms whowanttoborrow Copyright â 2004 South-Western Summary Nationalincomeaccountingidentitiesreveal someimportantrelationshipsamong macroeconomicvariables Inparticular,inaclosedeconomy,national savingmustequalinvestment Financialinstitutionsattempttomatchone personssavingwithanotherpersons investment Copyright â 2004 South-Western Summary • 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 • The demand for loanable funds comes from households and firms who want to borrow for investment Copyright © 2004 South-Western Summary • 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 • When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP Copyright © 2004 South-Western ... South-Western Summary • The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds • All these institutions act to direct the resources ... All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow Copyright â 2004 South-Western Summary Nationalincomeaccountingidentitiesreveal... savingmustequalinvestment Financialinstitutionsattempttomatchone personssavingwithanotherpersons investment Copyright â 2004 South-Western Summary • The interest rate is determined by the supply and demand for loanable funds