We learned in the previous chapter that two of the essential ingredients in economic growth are increases in the economy’s levels of human capital and physical capital. Human capital is largely provided by governments through public education. (In countries with a large private education sector, such as Canada, private post-secondary education is also an important source of human capital.) But physical capital, with the exception of infrastructure, is mainly created through private investment spending, that is, spending by firms rather than by the government. (You may also see it referred to simply as “investment.”)

Who pays for private investment spending? In some cases it’s the people or corporations that actually do the spending—for example, a family that owns a business might use its own savings to buy new equipment or a new building, or a corporation might reinvest some of its own profits to build a new factory. In the modern economy, however, individuals and firms that create physical capital often do it with other people’s money—money that they borrow or raise by selling stock.

To understand how investment spending is financed, we need to look first at how savings and investment spending are related for the economy as a whole. Then we will examine how savings are allocated among investment spending projects.

The most basic point to understand about savings and investment spending is that they are always equal. This is not a theory; it’s a fact of accounting called the savings-investment spending identity.

To see why the savings-investment spending identity must be true, let’s look again at the national income accounting that we learned in Chapter 7. Recall that GDP is equal to total spending on domestically produced final goods and services, and that we can write the following equation (which is the same as Equation 7-1):

where C is spending by consumers, I is investment spending, G is government purchases of goods and services, X is the value of exports to other countries, and IM is spending on imports from other countries.

The Savings-Investment Spending Identity in a Closed Economy In a closed economy, there are no exports or imports. So X = 0 and IM = 0, which makes Equation 10-1 simpler. As we learned in Chapter 7, the overall income of this simplified economy would, by definition, equal total spending. Why? Recall one of the basic principles of economics from Chapter 1, that one person’s spending is another person’s income: the only way people can earn income is by selling something to someone else, and every dollar spent in the economy creates income for somebody. This is represented by Equation 10-2: on the left, GDP represents total income earned in the economy, and on the right, C + I + G represents spending by all sectors in the economy:

As an individual, you can divide your income into two categories: spending (on final goods and services) and savings. The same logic applies to an economy as a whole. Any closed economy can divide its income into consumption spending and savings. Consumption spending comes from households (private sector consumption spending, C) and government (public sector consumption spending, G). The economy’s total savings, national savings (S_National), also comes from households and the government. So it must be true that:

Since (GDP − C − G) is the amount of total income left over after consumption spending, it must be equal to savings for the economy as a whole. Making use of Equation (10-2), we get:

This is why we can say that it’s a basic accounting fact that savings equals investment spending for the economy as a whole.

Now, let’s take a closer look at national savings. As mentioned earlier, national savings comes from both households and the government. Thus, another way to look at national savings is to look at savings undertaken by each of these two sectors. Recall from Chapter 7 that the savings undertaken by households is called private savings, S_Private, and this amount is equal to disposable income minus (private sector) consumption spending:

where GDP represents income, T represents taxes, and TR represents transfers from the government.

As alluded to above, the government can also save. The savings by the government is usually called public savings, S_Public, but you may also see it referred to as government savings. Public savings is the government’s budget balance—that is, does the budget have a surplus or a deficit, or does total income equal total spending. Like households, the government earns income and has spending on goods and services. The government’s income consists of the tax revenues it collects, while its expenditures include spending on final goods and services and making transfer payments to residents. Sometimes, it is convenient to refer to the difference between the tax revenues and transfer payments as net taxes, in essence treating transfer payments as negative taxes. Thus, the government’s budget balance is the difference between the net tax revenue and government spending on final goods and services. If net taxes exceed government spending on final goods and services, then the government is running a budget surplus. Since the budget balance is positive, the government has saved the leftover. On the other hand, if the budget balance is negative, the government runs a budget deficit, or “dissaves,” as the government is engaged in the opposite of savings. Therefore, the budget balance of the government is equivalent to public savings:

National savings can be expressed as the sum of private savings and public savings:

Substituting Equations (10-6) and (10-7) into Equation (10-8), we get back Equation (10-4):

The Savings-Investment Spending Identity in an Open Economy An open economy is an economy in which goods and money can flow into and out of the country. This changes the savings-investment spending identity because savings need not be spent on investment spending projects in the same country in which the savings are generated, and so the savings of people who live in any one country can be used to finance investment spending that takes place in other countries. Any given country can receive inflows of funds—foreign savings that finance investment spending in that country. Any given country can also generate outflows of funds—domestic savings that finance investment spending in another country.

The net effect of international outflows and inflows of funds on total savings available for investment in any given country is known as the net foreign investment (NFI) of that country. NFI is equal to the total outflows of domestic funds minus the total inflows of foreign funds.¹ Like the government budget balance, net foreign investment can be negative—when foreigners invest more money in a country than the country invests in other countries. This has happened in Canada in recent years. In 2010, for example, net foreign investment in Canada was negative C$30.5 billion, meaning that foreigners invested C$30.5 billion more in Canada than Canadians invested in other countries. The negative NFI was, in part, caused by uncertainty in the global economy. At time of writing, Canada had one of the best fiscal positions of all G-7 countries, with an AAA credit rating (the highest available). Owing to the sovereign debt crisis in the European Union and the downgrading of the U.S.’s credit rating from AAA to AA+, foreign investors perceived Canada as a safe place to store their wealth. Also, since 2008–2009, Canada’s trade balance has gone from a surplus to a deficit. This implies that the level of national savings fell short of domestic investment, and Canada needed to borrow from the rest of the world to finance a portion of this investment.

It’s important to note that, from a national perspective, a dollar generated by national savings and a dollar generated by a foreign capital inflow are not equivalent. Yes, they can both finance the same dollar’s worth of investment spending. But any dollar borrowed from a saver must eventually be repaid with interest. A dollar that comes from national savings is repaid with interest to someone domestically—either a private party or the government. But a dollar that comes as a foreign capital inflow must be repaid with interest to a foreigner. So a dollar of investment spending financed by a foreign capital inflow comes at a higher national cost—the interest that must eventually be paid to a foreigner—than a dollar of investment spending financed by national savings.

The fact that a negative net foreign investment represents funds “borrowed” from foreigners is an important aspect of the savings-investment spending identity in an open economy. Since financial capital can flow freely across national borders, an open economy can allocate in savings in two ways: accumulating physical capital (investing domestically) and acquiring foreign assets (investing abroad). This is equivalent to saying that the funds used to finance domestic investment can come from two sources: domestic funds (via national savings) and foreign funds (via capital inflows, or a negative NFI). It turns out a country’s net foreign investment is tied to its net exports. Why? When a country spends more on imports than it earns from exports, it must borrow the difference from foreigners to help pay for its imports. As a consequence, the country’s net foreign investment will turn negative. Similarly, when a country earns more from exports than it spends on imports, it must use the excess amount to fund investment abroad. So, it has a positive net foreign investment. As we’ll explain in greater detail in Chapter 19, the relationship between net foreign investment and net exports (the trade balance) is given by:

Rearranging Equation 10-1 we get:

The left side of Equation 10-10 is equal to national savings (Equation 10-4), so then:

Equation 10-11 shows that an open economy can split its savings into domestic investment (I) and net foreign investment (NFI). Let’s look at some data to demonstrate this. In 2010 in Canada, private savings reached $420.7 billion, while public savings were negative $90.2 billion. So, the government ran a budget deficit. This resulted in national savings of $330.5 billion. However, investment spending totalled $360.7 billion, which was greater than the amount of domestic funds available. The shortfall in funds was supplemented by a trade deficit of $30.5 billion. Thus, in 2010 Canada “borrowed” $30.5 billion from foreigners. You may have noticed these numbers don’t quite add up; because data collection isn’t perfect, there is a statistical discrepancy of $0.3 billion. But we know that the error lies in the data, not in the theory, because the savings-investment spending identity must hold in reality.

Figure 10-1 shows the savings-investment identity in Canada in 2007 and 2010. To make the comparison easier, we have measured different kinds of savings and investment as a percentage of GDP. In each panel, the bars on the left side show the sum of investment spending and net foreign investment as a percentage of GDP. The bars on the right side show the components of national savings as a percentage of GDP. The levels of investment spending as a percentage of GDP were roughly the same in both years; however, other components in the savings-investment identity changed quite a lot from 2007 to 2010.

Public savings changed from a positive 1.4% in 2007 to a negative 5.6% in 2010, which indicated the government’s budget balance changed from a surplus to a deficit. This change in budget balance was the result of an economic slowdown coupled with expansionary fiscal policies such as the Economic Action Plan and other programs implemented in response to the financial crisis. The increase in government spending, the provision of higher transfer payments, and a fall in tax revenues combined to force the federal government to run record-high deficits. In the 2012 Federal Budget, the federal minister of finance, Jim Flaherty, projected a budget surplus in the fiscal year of 2016–2017, which implied that public savings would remain negative, and the budget would remain in deficit, until 2016.

Similarly, Canada’s net foreign investment changed from a positive 1.9% in 2007 to a negative 1.9% in 2010. In 2007, Canada experienced positive NFI and “lent” money to foreigners; in 2010, Canada experienced negative NFI and “borrowed” from foreigners. The change in the nature of NFI also indicated that Canada’s trade balance changed from a surplus to a deficit. This change was caused partly by the recession in the United States, which lowered the demand for exported Canadian goods, and partly by falling oil prices.

On the other hand, the private sector saved more as a percentage of GDP over that period. Private savings increased from 23.7% of GDP in 2007 to 25.9% in 2010. This may have been triggered by heightened uncertainty about the future. Perhaps seeing that economic growth had slowed and firms were laying off workers as a result of the recent recession, households saved more for future rainy days! Although private savings as a percentage of GDP was higher in 2010, national savings actually fell to 20.3% of GDP as the increase in private savings was more than offset by a fall in public savings.

For the economy as a whole, savings always equals investment spending. In a closed economy, savings is equal to national savings. In an open economy, savings can be split between investment and net foreign investment. At any given time, however, savers, the people with funds to lend, are usually not the same as borrowers, the people who want to borrow to finance their investment spending. How are savers and borrowers brought together?

Savers and borrowers are matched up with one another in much the same way producers and consumers are matched up: through markets governed by supply and demand. In Figure 7-1, the expanded circular-flow diagram, we noted that the financial markets channel the savings of households to businesses that want to borrow in order to purchase capital equipment. It’s now time to take a look at how those financial markets work.

To do this, it helps to consider a somewhat simplified version of reality. As we noted in Chapter 7, there are a large number of different financial markets in the financial system, such as the bond market and the stock market. However, economists often work with a simplified model in which they assume that there is just one market that brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects). This hypothetical market is known as the loanable funds market. The price that is determined in the loanable funds market is the interest rate, denoted by i. As we noted in Chapter 8, loans typically specify a nominal interest rate. So although we call i “the interest rate,” it is with the understanding that i is a nominal interest rate—an interest rate that is unadjusted for inflation.

We’re not quite done simplifying things. There are, in reality, many different kinds of interest rates, because there are many different kinds of loans—short-term loans, long-term loans, loans made to corporate borrowers, loans made to governments, and so on. In the interest of simplicity, we’ll ignore those differences and assume that there is only one type of loan.

OK, now we’re ready to analyze how savings and investment get matched up.

The Domestic Demand for Loanable Funds The domestic demand for loanable funds (or, for short, the demand for loanable funds) comes from those who need to borrow funds to finance their domestic investment project(s). Figure 10-2 illustrates a hypothetical demand curve for loanable funds, D, which slopes downward. On the horizontal axis we show the quantity of loanable funds demanded. On the vertical axis we show the interest rate, which is the “price” of borrowing. But why does the demand curve for loanable funds slope downward?

To answer this question, consider what a firm is doing when it engages in investment spending—say, by buying new equipment. Investment spending means laying out money right now, expecting that this outlay will lead to higher profits at some point in the future. In fact, however, the promise of a dollar five or ten years from now is worth less than an actual dollar right now. So an investment is worth making only if it generates a future return that is greater than the monetary cost of making the investment today. How much greater? To answer that, we need to take into account the present value of the future return the firm expects to get. We examine the concept of present value in the accompanying For Inquiring Minds.

In present value calculations, we use the interest rate to determine how the value of a dollar in the future compares to the value of a dollar today. But the fact is that future dollars are worth less than a dollar today, and they are worth even less when the interest rate is higher. The intuition behind present value calculations is simple. The interest rate measures the opportunity cost of investment spending that results in a future return: instead of spending money on an investment spending project, a company could simply put the money into the bank and earn interest on it. And the higher the interest rate, the more attractive it is to simply put money into the bank instead of investing it in an investment spending project. In other words, the higher the interest rate, the higher the opportunity cost of investment spending. And, the higher the opportunity cost of investment spending, the lower the number of investment spending projects firms want to carry out, and therefore the lower the quantity of loanable funds demanded. It is this insight (discussed in the accompanying For Inquiring Minds) that explains why the demand curve for loanable funds is downward sloping.

When businesses engage in investment spending, they spend money right now in return for an expected payoff in the future. So, to evaluate whether a particular investment spending project is worth undertaking, a business must compare the present value of the future payoff with the current cost of that project. If the present value of the future payoff is greater than the current cost, a project is profitable and worth investing in. If the interest rate falls, then the present value of any given project rises, so more projects pass that test. If the interest rate rises, then the present value of any given project falls, then fewer projects pass that test. So total investment spending, and hence the demand for loanable funds to finance that spending, is negatively related to the interest rate. Thus, the demand curve for loanable funds slopes downward. You can see this in Figure 10-2. When the interest rate falls from 12% to 4%, the quantity of loanable funds demanded rises from $15 billion (point A) to $45 billion (point B).

The Domestic Supply of Loanable Funds The domestic supply of loanable funds (or, for short, the supply of loanable funds) comes from those who have extra funds that they are willing to lend. This supply is equal to national savings. Figure 10-3 shows a hypothetical supply curve for loanable funds, S. Again, the interest rate plays the same role that the price plays in ordinary supply and demand analysis. But why is this curve upward sloping?

The answer is that loanable funds are supplied by savers, and savers incur an opportunity cost when they lend to a business: the funds could instead be spent on consumption—say, a nice vacation. Whether a given saver becomes a lender by making funds available to borrowers depends on the interest rate received in return. By saving your money today and earning interest on it, you are rewarded with higher consumption in the future when the loan you made is repaid with interest. So it is a good assumption that more people are willing to forgo current consumption and make a loan to a borrower when the interest rate is higher. As a result, our hypothetical supply curve of loanable funds slopes upward. In Figure 10-3, lenders will supply $15 billion to the loanable funds market at an interest rate of 4% (point X); if the interest rate rises to 12%, the quantity of loanable funds supplied will rise to $45 billion (point Y).

The Equilibrium Interest Rate The equilibrium interest rate is the interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. As you can see in Figure 10-4, the equilibrium interest rate, i*, and the total quantity of lending, Q*, are determined by the intersection of the supply and demand curves, at point E. Here, the equilibrium interest rate is 8%, at which $30 billion is lent and borrowed. In this equilibrium, only investment spending projects that are profitable if the interest rate is 8% or higher are funded. Projects that are profitable only when the interest rate falls below 8% will not be funded. Correspondingly, only lenders who are willing to accept an interest rate of 8% or less will have their offers to lend funds accepted; lenders who demand an interest rate higher than 8% do not have their offers to lend accepted.

Figure 10-4 shows how the market for loanable funds matches up desired savings with desired investment spending: in equilibrium, the quantity of funds that savers want to lend is equal to the quantity of funds that firms want to borrow (point E). The figure also shows that this match-up is efficient, in two senses. First, the right investments get made: the investment spending projects that are actually financed have higher payoffs (in terms of present value) than those that do not get financed. Second, the right people do the saving and lending: the savers who actually lend funds are willing to lend for lower interest rates than those who do not.

The insight that the loanable funds market leads to an efficient use of savings, although drawn from a highly simplified model, has important implications for real life. As we’ll see shortly, it is the reason that a well-functioning financial system increases an economy’s long-run economic growth rate.

Before we get to that, let’s look at how the market for loanable funds responds to shifts of demand and supply. As in the standard model of supply and demand, where the equilibrium price changes in response to shifts of the demand or supply curves, here the equilibrium interest rate changes when there are shifts of the demand curve for loanable funds, the supply curve for loanable funds, or both.

Shifts of the Domestic Demand for Loanable Funds Let’s start by looking at the causes and effects of changes in demand.

The factors that can cause the demand curve for loanable funds to shift include the following:

Figure 10-5 shows the effects of an increase in the demand for loanable funds. S is the supply of loanable funds, and D₁ is the initial demand curve. The initial equilibrium interest rate is i₁. An increase in the demand for loanable funds means that the quantity of funds demanded rises at any given interest rate, so the demand curve shifts rightward to D₂. As a result, the equilibrium interest rate rises to i₂.

Shifts of the Domestic Supply of Loanable Funds Like the demand for loanable funds, the supply of loanable funds can shift. Among the factors that can cause the supply of loanable funds to shift are the following:

Figure 10-6 shows the effects of a decrease in the supply of loanable funds. D is the demand for loanable funds, and S₁ is the initial supply curve. The initial equilibrium interest rate is i₁. A decrease in the supply of loanable funds means that the quantity of funds supplied falls at any given interest rate, so the supply curve shifts leftward to S₂. As a result, the equilibrium interest rate rises to i₂.

The fact that a reduction in the supply of loanable funds leads, other things equal, to a rise in the interest rate has one especially important implication: it tells us that increasing or persistent government budget deficits are cause for concern because an increase in the government’s deficit shifts the supply curve of loanable funds to the left, which leads to a higher interest rate. If the interest rate rises, businesses and households will cut back on their investment spending. So, other things equal, a rise in the government budget deficit tends to reduce overall investment spending. Economists call the negative effect of government budget deficits on investment spending crowding out. It is a key reason for worry about increasing or persistent budget deficits, which explains why a government might put balancing the budget as one of its top priorities.²

Inflation and Interest Rates Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate. Historically, major changes in interest rates have been driven by many factors, including changes in government policy and technological innovations that created new investment opportunities. However, arguably the most important factor affecting interest rates over time—the reason, for example, that interest rates today are much lower than they were in the late 1970s and early 1980s—is changing expectations about future inflation, which shift both the supply and the demand for loanable funds.

To understand the effect of expected future inflation on interest rates, recall our discussion in Chapter 8 of the way inflation creates winners and losers—for example, the way that higher than expected Canadian inflation in the 1970s and 1980s reduced the real value of homeowners’ mortgages, which was good for the homeowners but bad for the banks. In Chapter 8 we learned that economists summarize the effect of inflation on borrowers and lenders by distinguishing between the nominal interest rate and the real interest rate, where the difference is:

The true cost of borrowing is the real interest rate, not the nominal interest rate. To see why, suppose a firm borrows $10 000 for one year at a 10% nominal interest rate. At the end of the year, it must repay $11 000—the amount borrowed plus the interest. But suppose that over the course of the year the average level of prices increases by 10%, so that the real interest rate is zero. Then the $11 000 repayment has the same purchasing power as the original $10 000 loan. In real terms, the borrower has received a zero-interest loan.

Similarly, the true payoff to lending is the real interest rate, not the nominal rate. Suppose that a bank makes a $10 000 loan for one year at a 10% nominal interest rate. At the end of the year, the bank receives an $11 000 repayment. But if the average level of prices rises by 10% per year, the purchasing power of the money the bank gets back is no more than that of the money it lent out. In real terms, the bank has made a zero-interest loan.

Now we can add an important detail to our analysis of the loanable funds market. Figures 10-5 and 10-6 are drawn with the vertical axis measuring the nominal interest rate for a given expected future inflation rate. Why do we use the nominal interest rate rather than the real interest rate? Because in the real world neither borrowers nor lenders know what the future inflation rate will be when they make a deal. Actual loan contracts therefore specify a nominal interest rate rather than a real interest rate. Because we are holding the expected future inflation rate fixed in Figures 10-5 and 10-6, however, changes in the nominal interest rate also lead to changes in the real interest rate.

The expectations of borrowers and lenders about future inflation rates are normally based on recent experience. In the late 1970s, after a decade of high inflation, borrowers and lenders expected future inflation to be high. By the late 1990s, after a decade of fairly low inflation, borrowers and lenders expected future inflation to be low. And these changing expectations about future inflation had a strong effect on the nominal interest rate, largely explaining why nominal interest rates were much lower in the early years of the twenty-first century than they were in the early 1980s.

Let’s look at how changes in the expected future rate of inflation are reflected in the loanable funds model.

In Figure 10-7, the curves S₀ and D₀ show the supply and demand for loanable funds given that the expected future rate of inflation is 0%. In that case, equilibrium is at E₀ and the equilibrium nominal interest rate is 4%. Because expected future inflation is 0%, the equilibrium expected real interest rate over the life of the loan is also 4%.

Now suppose that the expected future inflation rate rises to 10%. The demand curve for loanable funds shifts upward to D₁₀: borrowers are now willing to borrow as much at a nominal interest rate of 14% as they were previously willing to borrow at 4%. That’s because with a 10% inflation rate, a 14% nominal interest rate corresponds to a 4% real interest rate. Similarly, the supply curve of loanable funds shifts upward to S₁₀: lenders require a nominal interest rate of 14% to persuade them to lend as much as they would previously have lent at 4%. The new equilibrium is at E₁₀: the result of an expected future inflation rate of 10% is that the equilibrium nominal interest rate rises from 4% to 14%.

This situation can be summarized as a general principle, known as the Fisher effect (after the American economist Irving Fisher, who proposed it in 1930): In the long run, the expected real interest rate is unaffected by changes in expected future inflation. According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point. The central point is that both lenders and borrowers base their decisions on the expected real interest rate. As a result, a change in the expected rate of inflation does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium nominal interest rate.