Birks – Mankiw 7th edn Chapter 26: Saving, Investment and the Financial System
Mankiw, N. G. (2015) Principles of economics (7th ed.) Ch.26
Principles of macroeconomics (7th ed.) Ch.13
Mason, OH: South-Western Cengage Learning
Saving, Investment and the Financial System
When reading the chapter, here are some aspects to consider:
1. Note that in these chapters Mankiw is talking about the real economy in the long run. He is assuming that the economy is at equilibrium and at full employment. The short run is not discussed until Chapter 33, Aggregate Demand and Aggregate Supply.
2. We could think of the function of the economy being the production and allocation of goods and services. This occurs in the “real” side of the economy. To enable it to occur smoothly, we use prices to indicate relative values of goods and services, and money to facilitate exchange. This role, as a medium of exchange, is one of the functions of money considered later in Chapter 29, The Monetary System. We could consider money flows, financial institutions and overall price levels as being the financial side of the economy. Whether it performs well or not could be judged in terms of how it affects the operation of the real economy. Without money, we rely on barter, which requires the “double coincidence of wants” (each party to the transaction must want something that the other is offering to exchange). This is more restrictive than money transactions, where people are prepared to accept money in exchange for goods and services in the knowledge that they can then exchange the money for goods and services elsewhere.
This diagram may help you to see how Mankiw links the financial and real sectors:
Be careful, though. Saving and investment in the real economy refers to units of final demand of goods and services. Lending and borrowing in the financial sector should refer to financial arrangements. Mankiw fudges this.
3. This is not mentioned, but may be of interest to some of you when looking for something to read. In 1873 Walter Bagehot’s book, Lombard Street: a description of the money market, was published. It described the operation of banks, the importance of institutional arrangements, the role of a central bank and policy responses in financial crises. It is a good, short read and is still relevant today. Financial commentators drew on the points raised when discussing options in the recent/current global financial crisis.
4. And here is another additional point that may be of interest. Some stocks are identified as “growth stocks”. Investors are prepared to get a lower rate of dividends on such stocks because they expect capital gains, growth in the price of the shares. This can lead to a distortion. Consider standard manufacturing companies giving dividends at about 10% of the share price, while growth stocks may be attractive at 5%. Some growth stocks are companies which buy up other companies. If such a company buys a manufacturing company at $100m, getting $10m net earnings each year. It pays the prevailing price and raises the money through the stock exchange. Net earnings have increased by $10m, and market value of the company has, at first, increased by $100m. This would mean that earnings are more than 5% of the share value, so the share price is likely to rise until the market capitalisation is $200m higher than before the acquisition. This works so long as people continue to see it as a growth stock. If no further growth is expected, then a 10% dividend might be required. This would be associated with a halving of the share price, which could even lead to panic selling. Points such as this are discussed in Malkiel (2003).
5. Mankiw tries to simplify, but goes so far that it is problematic. His presentation of income and expenditure is based on an accounting approach, so that income always equals expenditure. It is an identity. That does not mean that everyone is satisfied with that position. He is really saying that aggregate income equals realised aggregate expenditure, which is an identity because all spending on final goods and services is received by someone. A more conventional approach would distinguish between planned and realised expenditure. Recall that unsold output of final goods is still counted in GDP. It is included under investment (we are assuming that these goods are durable, and so can be stored for later sale). If the intention had been to sell the goods, we would refer to this as unplanned additions to inventory. If they arise, producers have an incentive to produce less in the next period. Conversely, if current sales exceed current output, the extra supply comes from past production. If this was not intended by producers, we would refer to it as unplanned reductions in inventory, and it would result in realised investment being lower than planned investment. Producers have an incentive to increase production in the next period.
6. Note that we can consider equilibrium in economics as being a situation where plans are realised. If plans are not realised, some people have an incentive to change and the economy may move to another position.
We can now link this to Mankiw’s description. First, he does not give a model for equating planned and realised expenditure. I have given some of the features of such a model above, showing possible behaviour out of equilibrium. This is analogous to responses in a supply and demand model where supply does not equal demand, although without mentioning prices. It is best to ignore prices at this stage, noting that the price level is not the same as an individual price; it cannot indicate relative values.
Mankiw then presents a financial market as if demand is based on investment and supply on savings. This also is a simplification, but does indicate some of the issues of concern to us. Simplifying assumptions or concerns about Mankiw’s approach include:
- All money that is saved is then borrowed by someone else.
- There is no borrowing for items such as a mortgage on an existing home.
- It is not clear how the model handles savings which are retained for several years (as for retirement).
- In reality money is not just for flows in the circular flow, but also for intermediate transactions.
7. Despite the simplifying assumptions, it does give some indication of the way policy changes can influence interest rates, thus affecting investment. Mankiw is very restricted in his description due to his failure to include a model to derive equilibrium income. The Keynesian Cross model incorporates some of the necessary features. It can help to consider this model now. You can find it described in Mankiw (2013, pp. 305-311). It does help to treat this as an additional reading if you want to understand both the chapter material and the general process of developing interlinked models to get an increasingly detailed representation of an economy.
If you do look at that reading, the following points give some additional discussion linking it in to the current chapter:
8. The Keynesian Cross model assumes a fixed price level, but allows us to consider determinants of aggregate demand and the way an economy might adjust if realised expenditure does not match planned expenditure. Surprisingly, given his simplification in your text, Mankiw overcomplicates his description in the intermediate text. His consumption function and expenditure function are linear, with constant slope equal to the marginal propensity to consume (MPC). Nevertheless, he uses infinite series and calculus to explain the multiplier process. He could have simply given the consumption function as:
C = a + b(Y-T)
Where b = MPC.
Then he could have replaced C’ in footnotes 3 and 4 with “b”. The government purchases multiplier would then be 1/(1-b) and the tax multiplier would be –b/(1-b).
9. Now you are ready to understand some of the reasons why Mankiw has problems, note the following.
In this chapter (and elsewhere in the book) there is no explanation as to how the level of income, Y, is determined. Mankiw breaks expenditure down into its standard components, but as realised expenditure, not planned expenditure. This is why he has an identity. In fact, as this and the other chapters surrounding it are for “The real economy in the long run”, it is assumed that the economy is at equilibrium at the full employment level of income. Any change in spending in the long run is then simply a reallocation of this fixed output over the components of expenditure.
In the Keynesian Cross model the expenditure line and its components refer to planned expenditure. Saving changes as income changes, so investment and saving can become equal through changes in income. Mankiw’s Principles text only allows changes through varying the interest rate, implicitly assuming that income is constant (note the ceteris paribus assumption in such models). The only response his three policy options show is a change in investment and saving due to changes in interest rate for a constant level of income.
The financial market that he presents is described as if it relates to planned investment and saving in that the quantities are those that people want to invest or save, but it is then assumed that the quantities are the realised amounts. Hence we must be at equilibrium with all plans realised. He also assumes that all saved money is then loaned for new investment. In reality, financial institutions hold some reserves, and people borrow to buy existing assets and well as new ones. There are also issues with the link between saving as a withdrawal from the circular flow and as a measure of available funds in financial markets, but that is moving into more involved issues.
The Keynesian Cross model in the additional reading does not consider the links between interest rate and investment, but the model can be extended to include such a relationship. It can be used to consider the effect on equilibrium income of a change in G, for example, but with either interest rate assumed constant or saving and investment assumed independent of interest rate. This might illustrate for you the way basic models can be constructed and then gradually expanded to consider more influences.
Malkiel, B. G. (2003). A random walk down Wall Street: the time-tested strategy for successful investing. New York: W.W. Norton.
Mankiw, N. G. (2013). Macroeconomics (8th ed.). New York, NY: Worth.
Commentary by Stuart Birks, last updated 27 November 2014