Saving Investment and the Financial System

Imagine that you have just .graduated from college (with a degree .in economics, of’course) and, you side to start your own ‘business-an economic forecasting firm, Before you maker any ‘money selling your forecasts; you have to incur substantial costs to set up your business, You have to buy Computers with which to make your forecasts, as well as desks, chairs, and filing cabinets to furnish your new office, Each Of these items is a,type of capital that your firm will use to produce and sell its services How do you obtain the funds to invest in these capital goods? Perhaps you are able to pay for them out of your past savings. More likely, however, like most entrepreneurs, you do, not have enough money of your own finance the start of your business. As a result, you have to get the money you need from other sources. There are various ways to finance these capital investments. You could borrow the Niamey, perhaps from a bank~r from a friend or relative. is this case, you would promise not only to’ return the money at a later date but also to pay interest for the ‘use of the money. Alternatively, you could convince someone to provide the money you need for your business in exchange for a,share of your future profits, whatever they might happen to ‘be. In her case, your investment in computers and’ office equipment is being financed by someone else’s saving The financial system consists of those institutions in the economy that help to match ‘one person’s saving with another person’s investment. As we discussed in the previous chapter, saving and investment are key ingredients-to long-run economic growth When a country saves a large portion of its GDP, more resources are available in capital, and higher capital raises and living standard The previous chapter, however, did not no the economy coordinates saving and investment At ‘any time-some people want to save some of their income’ for the future, and others want to borrow to Atman investments ‘new and  businesses.What brings these two groups Of people together? What ensures that the supply of funds from those who want to save balances the demand for funds from those who’,want to’ investment This chapter examines-how-the financial system works. First, we discuss the large variety of institutions that ~e up the financial s,stem 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 In the model, the interest rate is the price that adjusts to balance supply and demand. The model shows how various government policies affect the interest rate and, thereby, society’s allocation of scarce resources.

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