Macroeconomics

F I G U R E

3 - 8

Real interest rate, r

S

Saving , S

Investment, Saving, I, S

Desired investment, I(r)

Equilibrium

interest

rate

Saving, Investment, and

the Interest Rate

The

interest rate adjusts to

bring saving and invest-

ment into balance. The

vertical line represents 

saving—the supply of 

loanable funds. The 

downward-sloping line

represents investment—

the demand for loanable

funds. The intersection of

these two curves deter-

mines the equilibrium

interest rate.

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is unchanged, so consumption C is unchanged as well. Therefore, the increase in

government purchases must be met by an equal decrease in investment.

To induce investment to fall, the interest rate must rise. Hence, the increase in

government purchases causes the interest rate to increase and investment to

decrease. Government purchases are said to crowd out investment.

To grasp the effects of an increase in government purchases, consider the

impact on the market for loanable funds. Because the increase in government

purchases is not accompanied by an increase in taxes, the government finances

the additional spending by borrowing—that is, by reducing public saving. With

C H A P T E R   3

National Income: Where It Comes From and Where It Goes

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FYI

The model presented in this chapter represents

the economy’s financial system with a single

market—the market for loanable funds. Those

who have some income they don’t want to con-

sume immediately bring their saving to this mar-

ket. Those who have investment projects they

want to undertake finance them by borrowing in

this market. The interest rate adjusts to bring

saving and investment into balance.

The actual financial system is a bit more com-

plicated than this description. As in this model,

the goal of the system is to channel resources

from savers into various forms of investment. But

the system includes a large variety of mechanisms

to facilitate this transfer of resources.

One piece of the financial system is the set of

financial markets through which households can

directly provide resources for investment. Two

important financial markets are the market for

bonds and the market for stocks. A person who buys

a bond from, say, Apple Corporation becomes a

creditor of the company, while a person who buys

newly issued stock from Apple becomes a part

owner of the company. (A purchase of stock on a

stock exchange, however, represents a transfer of

ownership shares from one person to another and

does not provide new funds for investment pro-

jects.) Raising investment funds by issuing bonds

is called debt finance, and raising funds by issuing

stock is called equity finance.

Another piece of the financial system is the set

of financial intermediaries through which households

can indirectly provide resources for investment. As

the term suggests, a financial intermediary stands