Question

How does a well-functioning financial system increase saving (S) and investment (I), holding constant the budget balance and any capital flows?

The best way to think about the above question is to consider what would happen to the economy if S > I, or vice versa. An important assumption is to ignore the budget balance (assume there is no government) or any capital flows (also assume a closed economy), and focus only on the market for loanable funds.

Answer 1

 Closed economy is a state in which a country does not trade with other countries. This means that all goods and services are produced and consumed domestically.

 In a closed economy, all output Y is consumed or invested by the private sector- domestic households and businesses-or purchased by the government

 In a closed economy savings can only be used for domestic investment

 In a closed economy if the government reduce the expenditure the government borrowing will come down and in the loanable fund market there will be less demand for

 the funds. Govemrnt plays large role in the spending in an economy.

 Given that there is no government or any capital flows also assuming that it is a closed economy , if the saving increase in the economy , the interest rates will come down. This will move the money from savings to investment in the business and production. It will improve the output and employment and lead to increase in the growth of the

 country.

 It will improve the production and consumption in the economy. This will increase the GDP, the relative price will come down , real GDP will increase and the national supply of goods will also increase.