Macroeconomics: Saving, Investment, and International Finance

What is national saving (formula, expanded)?

National saving is total income remaining after private consumption and government spending

S = (Y - C - T) + (T - G)

What is private saving?

Private saving is the income households have left after paying taxes and consuming goods and services.

Y - C - T

What is public saving?

Public saving is the amount of tax revenue the government has after deducting its own expenditures.

T - G

When is investment equal to saving? Why?

In a closed economy, national saving is equal to investment as an accounting identity. Since Y = C + I + G, and S = Y - C - G, substituting leaves S = I.

When is desired saving and desired investment equal? Why?

Desired saving equals desired investment at the equilibrium real interest rate. The real interest rate adjusts to balance the supply of loanable funds (desired saving) with demand for loanable funds (desired investment).

Why might saving be greater than investment?

At a given real interest rate, desired saving may exceed desired investment, creating excess supply of loanable funds. The real interest rate falls, encouraging firms to invest more and households to save less until equilibrium is restored.

Why might investment be greater than saving?

At a given real interest rate, desired investment may exceed desired saving, creating excess demand for loanable funds. The real interest rate rises, encouraging more saving and discouraging investment until equilibrium is restored.

How does an increase in GDP not necessarily entail an increase in saving?

Because consumption may also increase. People tend to consume more when income increases permanently, save more of temporary income increases, and may increase consumption today if they expect higher future income.

What is the financial system?

The financial system is the network of financial institutions and markets that channels funds from savers to firms undertaking investment projects, ideally allocating saving toward profitable investments with manageable risk.

What are the primary financing methods?

1. Reinvested earnings: using a firm's own profits.

2. Debt finance: borrowing through bank loans or bonds.

3. Equity finance: issuing and selling ownership shares in exchange for capital.

What is reinvested earnings?

Reinvested earnings involve using a firm's existing profits to finance investment. This avoids external borrowing and issuing shares, but has an opportunity cost from forgone interest and requires sufficient existing profits.

What is debt finance?

Debt finance involves borrowing funds through banks loans or issuing bonds, with an obligation to repay. Banks act as intermediaries between savers and borrowers, while bonds allow firms to borrow directly from investors.

What is equity finance?

Equity finance involves raising capital by selling ownership in a firm through stocks or shares. It avoids debt repayment obligations but dilutes existing owners' percentage ownership and potentially their control.

What is the difference between issuing bonds versus stocks?

Issuing stocks sells company ownership to raise capital, while issuing bonds borrows money from investors that must be repaid with interest.

What is the supply of loanable funds?

The supply of loanable funds represents desired national saving at each real interest rate. It generally slopes upward because higher real interest rates encourage more saving.

What is the demand for loanable funds?

The demand for loanable funds represents desired private investment at each real interest rate. It generally slopes downward because higher real interest rates make fewer investment projects profitable.

What shifts the supply curve in the loanable funds market?

Factors changing the desire or ability to save, such as: (1) retirement saving, (2) precautionary saving, (3) bequest motives, (4) taxation of interest income and estates, (5) pension systems, (6) and government saving.

What shifts the demand curve in the loanable funds market?

Factors affecting firms' desire to invest, including productivity of capital and risk. Examples include better business conditions, a larger labor force, lower corporate taxes, technological breakthroughs, and stronger investor confidence ("animal spirits").

How is the long-/short- run distinction important in the loanable funds market?

In the long run, real interest rates are determined by desired saving and investment in the loanable funds market. In the short run, the Federal Reserve can influence interest rates to stimulate investment during recessions or restrain economic activity to combat inflation.

What are the special cases in the loanable funds market?

Consumer borrowing for consumption is treated as negative saving rather than investment demand. Mortgages financing newly constructed homes count toward investment demand because new residential construction is considered investment

What are consumer loans?

Consumer loans are funds borrowed to finance consumption, such as car purchases or credit card spending. In the loanable funds model, these are treated as negative saving rather than demand for investment funds.

What are mortgage loans?

Mortgage loans are loans used to finance home purchases. Mortgages on newly constructed houses count as demand for loanable funds because new residential construction is investment; purchasing an existing house does not create new residential investment.

What is crowding out?

Crowding out occurs when increased government borrowing reduces national saving available for private investment, shifting the supply of loanable funds left, reducing private investment.

When does the government cause a crowding out effect?

When government spending increases without corresponding tax increases, public and national saving fall, raising interest rates and reducing private investment. Tax cuts can also reduce national saving and cause crowding out. Tax-financed spending may cause a smaller effect if consumption falls by less than the tax increase.

What is "crowding in?"

Crowding in occurs when government expenditure encourages additional private investment. Productive government spending, such as infrastructure or education, can increase capital productivity, while spending during recessions can stimulate demand and improve incentives to invest.

Why have global interest rates downtrended since the 1980s?

Global real interest rates have fallen even though saving has remained around 25% of world GDP, suggesting both increased desired saving (supply shifting right) and decreased desired investment (demand shifting left). Saving increased due to longer lifespans, fewer children, and China's high saving rate. Investment demand decreased due to slower growth, less capital-intensive technology, and greater risk aversion after the financial crisis.

What is present value (formula)?

Present value is the value today of a future payment, discounted by the interest rate.

What is time value of money?

Money today is more valuable than the same amount of money in the future because we can save or invest it and earn interest.

What is the yield to maturity of a bond, and how does it differ from the market interest rate?

Both interest rates and yields measure the percentage cost of borrowing or return from lending. The interest rate is explicitly stated in a loan or deposit contract, while a bond's yield is the implied rate of return determined by its market price and future cash flows.

How do we calculate the yield of a one-year zero-coupon bond (formula)?

Y = (FV - P) / P

What is the relationship between bond prices and yields?

Bond prices and yields are inversely related: when the market price (P) increases, the yield decreases, and vice versa.

What is the relationship between bond prices and the market interest rate?

Bond prices and market interest rates are also inversely related: When market interest rates rise, existing bond prices fall because buyers require a larger discount to earn the higher market yield. Vice versa.

What is compounding?

The process of earning interest on both the original amount and previously accumulated interest, assuming constant interest rates.

How do we account for changing interest rates in present value calculations (formula)?

PV = FV / [(1+r1)(1+r2)]

What is defaulting?

Defaulting means that a borrower fails to repay money they owe according to the terms of a loan or bond.

What is a zero-coupon bond?

A zero-coupon bond is a bond that makes no periodic interest payments. Instead, it is sold at a discount to its face value.

What is the discount of a zero-coupon bond (go through an example)?

Suppose an issuer (borrower) sells a $900 bond. The investor (lender) paid $900 today in exchange for the promise of receiving $1000 at maturity. At maturity, the issuer repays $1000, so the investor earns $100, assuming no default. The $100 difference is the discount, not the amount the investor initially pays.

What is the market price of a zero-coupon bond?

The price investors pay to purchase the bond today. Ideally, it reflects the present value of its expected payment at maturity, which equals its face value if the issuer repays the bond as promised.

What is the face value (par value) of a zero-coupon bond?

A zero-compound bond's face value is the amount the issuer promises to repay at maturity.

What is a coupon-bond? What is the coupon rate?

A coupon bond is a bond that pays periodic interest payments (coupons) and repays its face value at maturity. The coupon rate is the annual coupon payment divided by the face value.

What is the price of a coupon-bond (formula)?

The current market price of a coupon bond is the sum of the present values of all future coupon payments and the face value repaid at maturity.

What is the efficient market hypothesis?

The Efficient Market Hypothesis states that asset prices reflect all available information about expected future cash flows. Therefore, prices change in response to new information, making future price movements unpredictable.

Why is consistently outperforming an efficient market unfeasible?

Because all publicly available information is already reflected in asset prices, investors cannot reliably predict new information or consistently earn superior returns using existing information.

What is fundamental analysis?

Fundamental analysis is a method of valuing an asset by calculating the present value of its expected future cash flows.

What is the fundamental value of an asset (definition, formula)?

An asset's fundamental value is the present value of all expected future payments it generates, including any expected resale value.

The fundamental value is calculated by discounting each expected future cash flow and the expected resale price to their present values, then adding them together.

What are dividends?

Dividends are payments made by a company to its shareholders, typically from its profits, as a return on their ownership of the company's stock.

How are discounting, present value, and fundamental value related?

Discounting converts future cash flows into their present values using an interest rate. An asset's fundamental value is calculated by adding together the present values of all its expected future cash flows.

What is a speculative bubble?

A speculative bubble occurs when an asset's market price rises far above its fundamental value due to overly optimistic or false expectations about its future value.

Why is investment positively correlated with stock prices?

Higher stock prices generally signal higher expected future profits, indicating that an industry may offer attractive investment opportunities. Firms respond by increasing investment. However, speculative bubbles can produce misleading signals and cause overinvestment.

What happened with the "Dot-com" bubble?

During the late 1990s, investors overestimated the future profitability of technology companies, causing stock prices to exceed fundamental values and encouraging excessive investment. The bubble began bursting in March 2000, and the NASDAQ lost 78% of its value by October 2002. Many companies went bankrupt, investment collapsed, and the economy experienced a mild recession in 2001.

What happened with the housing bubble?

Low interest rates, speculation, and securitization contributed to rising house prices and excessive residential investment. When the bubble burst, house prices fell, construction declined, and many homeowners defaulted on mortgages. Banks suffered major losses, reduced lending, and contributed to the financial crisis and Great Recession of 2008-2009.

What is securitization?

Securitization is the process of pooling loans, such as mortgages, and selling securities (a tradable financial asset) backed by those loans to investors. These mortgage-backed securities provide investors with payments funded by the underlying mortgages, while allowing banks to obtain funds for additional lending.

What is a security?

A security is a tradable financial asset, such as a stock or bond, that represents an ownership interest or financial claim.

What are the benefits of securitization? The problems?

Benefits: Securitization connects borrowers to a larger pool of savings, increases access to financing, reduces borrowing costs, and allows banks to issue more loans.

Problems: Banks have less incentive to carefully screen borrowers because they can sell the mortgages. This encourages risky lending, while investors may underestimate default risk. Rising defaults reduce MBS values, causing bank losses and reduced lending.

What are the two types of international transactions that open economies engage in?

International trade, which involves buying and selling goods and services between countries, and capital flows, which involve international borrowing, lending, and investment.

What is international trade?

International trade is the exchange of goods and services between countries. It allows countries to specialize according to comparative advantage, gives consumers greater product variety, and allows firms to benefit from economies of scale.

What are capital flows? What do they do for a country?

Capital flows are movements of financial capital between countries through borrowing, lending, and investment. They allow countries to finance domestic investment or consumption using funds from abroad.

What are capital outflows?

Capital outflows occur when domestic residents purchase foreign assets or lend money abroad, transferring financial capital to another country.

What are capital inflows?

Capital inflows occur when foreign residents purchase domestic assets or lend money to the domestic economy, bringing foreign financial capital into the country.

Net exports are also called what?

The trade balance.

What is the fundamental identity of an OPEN economy?

S − I = NX = NCO

Unlike in a closed economy, saving does not necessarily equal domestic investment because countries can borrow from or lend to the rest of the world.

What is the fundamental identity of an CLOSED economy?

S = I

This follows from Y = C + I + G and S = Y − C − G.

A trade surplus means... (relationship between S and I, and interpretation)

A trade surplus occurs when exports exceed imports (NX > 0). National saving exceeds domestic investment (S > I), meaning the country is a net lender to the rest of the world and experiences net capital outflows.

A trade deficit means... (relationship between S and I, and interpretation)

A trade deficit occurs when imports exceed exports (NX < 0). Domestic investment exceeds national saving (S < I), meaning the country is a net borrower from the rest of the world and experiences net capital inflows.

Balanced trade means... (relationship between S and I, and interpretation)

Balanced trade occurs when exports equal imports (NX = 0). National saving equals domestic investment (S = I), meaning the country experiences no net international capital flows.

What are net capital outflows?

Net capital outflows (NCO) represent the difference between domestic purchases of foreign assets and foreign purchases of domestic assets. Positive NCO indicates net lending abroad, while negative NCO indicates net borrowing from abroad.

How are net capital outflows and net exports related?

Net capital outflows always equal net exports (NCO = NX) in the simplified open-economy model. Export revenue not spent on imports corresponds to acquiring foreign assets, while imports exceeding exports must be financed by net capital inflows. Therefore, trade balances and net capital flows are two sides of the same economic relationship.

If a country imports more than it exports, how must the difference be financed?

The difference must be financed through net capital inflows, meaning the country borrows from abroad or foreigners purchase domestic assets.

If a country exports more than it imports, what must happen to the excess revenue?

The excess revenue must correspond to net capital outflows, meaning the country acquires foreign assets or lends money abroad.

What is the balance of payments?

The balance of payments records all international economic transactions involving a country. It consists of the current account and financial account, which reflect international income transactions and capital flows.

What are international income transactions?

International income transactions are payments of income between residents of different countries. These include wages, dividends, and profits that are earned from abroad.

What is the current account?

The current account records international trade in goods and services and income from abroad, including wages, dividends, and profits. In our simplified model, it is represented by net exports (NX).

What is the financial account?

The financial account records international capital flows, including foreign direct investment, foreign portfolio investment, and international loans.

What is foreign direct investment?

Foreign direct investment (FDI) involves building or acquiring productive businesses in another country to take advantage of profitable opportunities. It can create jobs and introduce new technologies to the receiving country.

What is foreign portfolio investment?

Foreign portfolio investment involves purchasing foreign financial assets, such as stocks and bonds. It is generally more volatile than FDI because investors can quickly sell their assets and withdraw capital when risks increase.

What are international loans?

International loans involve lenders in one country providing funds to borrowers in another country, with the expectation of repayment, usually with interest.

Why has the U.S. been such a large borrower for an extended period of time?

The U.S. has relatively low national saving, partly due to government budget deficits; attractive domestic investment opportunities, especially during the technology boom; and safe-haven status, which attracts foreign investors seeking secure financial assets.

Why are persistent deficits not necessarily an immediate economic problem?

Trade deficits can persist as long as foreign investors remain willing to lend to the country or purchase its assets. Countries have long time horizons, and the U.S.'s safe-haven status allows it to attract foreign financing for extended periods.

What is the nominal exchange rate?

The nominal exchange rate is the price of one currency expressed in another currency. In our model, e represents the amount of foreign currency per U.S. dollar.

What is appreciation (exchange rates)?

Appreciation occurs when a currency increases in value relative to another currency.

What is depreciation (exchange rates)?

Depreciation occurs when a currency decreases in value relative to another currency.

What generally causes appreciation of a currency? Why?

Increased demand for a country's goods or financial assets generally causes appreciation. Capital inflows especially increase demand for domestic currency because foreign investors purchase domestic assets, raising the currency's value.

What are real exchange rates (description, formula)?

The real exchange rate is the nominal exchange rate adjusted for differences in price levels between countries.

RER = (e × P) / P*

What do real exchange rates measure?

Real exchange rates measure the relative price of domestic goods and services compared with foreign goods and services. A higher RER means domestic goods are relatively more expensive.

What does a high RER mean for producers relying on imported machinery and inputs?

A high RER benefits these producers because imported machinery and intermediate goods become relatively cheaper, reducing their production costs.

What does a high RER mean for domestic producers?

A high RER generally hurts domestic producers because their goods become relatively more expensive and less competitive in international markets, making exports harder to sell.

What does a high RER mean for domestic consumers?

A high RER generally benefits domestic consumers because foreign goods become relatively cheaper, increasing their purchasing power over imports.

Is a high RER good or bad? Why?

A high RER is neither inherently good nor bad. It benefits consumers and producers relying on imported inputs but hurts exporters. Its overall implications depend on the cause: strong international demand for domestic goods and assets can be positive, while higher domestic production costs can be negative.

What is Purchasing Power Parity (PPP)?

Purchasing Power Parity (PPP) is a basic theory of exchange rates, stating that similar goods should cost approximately the same across countries when their prices are expressed in a common currency. Otherwise, people could buy goods where they are cheaper and resell them where they are more expensive. If PPP holds, RER = 1.

What are the limitations of PPP?

PPP often fails because many goods and services are nontradable, such as haircuts and transportation. Even tradable goods can have different prices due to transportation costs and consumer preferences. Capital flows also contribute to real exchange rate deviations.

Why do economists care about PPP?

Economists use PPP as a long-run benchmark for exchange rates. It works relatively well in high-inflation countries, where rising domestic prices generally cause currency depreciation. It also suggests that large real exchange rate deviations may eventually diminish.

What is true about PPP and developing countries?

Developing countries generally have real exchange rates below one (RER < 1) because their nontradable goods and services are relatively inexpensive compared with those in developed countries.

What is the fundamental equation for the loanable funds market in an open economy?

S = I + NCO

Saving can finance domestic investment or the acquisition of foreign assets.

What does demand for loanable funds in an open economy depend on?

Both components of demand (I + NCO) depend negatively on the domestic real interest rate. Higher interest rates make domestic investment more expensive and domestic assets more attractive, reducing desired investment and net capital outflows.

What is the domestic real interest rate's relation to NCO?

NCO depends negatively on the domestic real interest rate. Higher domestic interest rates make domestic assets more attractive relative to foreign assets, decreasing net capital outflows. Lower domestic rates increase NCO.

What causes movement along the NCO curve? What causes a shift?

Changes in the domestic real interest rate cause movement along the NCO curve. Changes in the attractiveness of foreign assets relative to domestic assets, such as foreign interest rates, investment opportunities, or political risks, shift the entire NCO curve.

What is the relation between net exports and the real exchange rate?

Net exports depend negatively on the real exchange rate. A higher RER makes domestic goods relatively more expensive, reducing exports and encouraging imports, thereby decreasing NX. A lower RER increases NX.

What shifts the supply of loanable funds?

Changes in national saving at each real interest rate, including private saving behavior, retirement and precautionary saving, tax incentives, pension policies, and government budget deficits. Increased saving shifts supply right; decreased saving shifts it left.

What shifts the demand for loanable funds?

Changes in domestic investment opportunities or the attractiveness of foreign assets. Higher domestic capital productivity increases I and shifts demand right, while more attractive foreign investments increase NCO and also shift demand right.

What shifts NCO?

Changes in the relative attractiveness of foreign versus domestic assets, including foreign interest rates, foreign investment opportunities, business climates, and international capital flight. More attractive foreign assets shift NCO right; less attractive foreign assets shift it left.