ECON 201 B Week 3 Notes

General Information

• Instructor: Elliot Spears
• Email: espear1@uw.edu
• First Article Response Due: Wednesday the 23rd
• Midterm: Monday, May 5th

Financial Markets

• Definition: Markets where the government, firms, and individuals trade promises to pay in the future.
• Importance:
  • Source of raising capital through stocks and bonds.
  • Enables borrowing, which is crucial for growth.

Cosma Shalizi Quote

• Financial markets facilitate the movement of money from those who have more than they need to spend to those who want to spend more than they have, improving overall welfare.

Financial Assets

• Types:
  • Loans: Agreements between a lender and a borrower.
  • Bonds: Issued by a borrower, promising to pay a fixed interest amount annually and repay the principal.
  • Loan-backed securities: Assets created by pooling loans (e.g., mortgage-backed securities) and selling shares in the pool.
  • Stocks: Represent a share in the ownership of a company.

Financial Intermediary

• Definition: An institution that transforms funds from individuals into financial assets.
• Examples:
  • Mutual fund: Creates a stock portfolio and resells shares to investors.
  • Pension fund: Holds assets to provide retirement income.

Savings

• Definition: The portion of income not spent.
• Formula: $Income = Consumption + Savings$, or $Y = C + S$
• Rearrangement: $S = Y - C$ (Savings is what remains after consumption).

Savings in a Simplified Economy (G=0, NX=0)

• National income accounting identity: $Y = C + I$
• Rewriting: $Y - C = I$
• Since $S = Y - C$, then $S = I$ (Savings equals investment by definition).

Savings with Government Included

• National income accounting identity: $Y = C + I + G$
• Government's role: Taxes and borrowing.

Taxes and Savings

• Taxes reduce income available for spending and saving.
• Disposable income: $Y - T$
• Private saving: $Y - T - C$
• Public saving: $T - G$

National Savings

• Formula:
  • $Y = C + I + G$
  • $Y – C – G = I$
  • $Y – T – C + T – G = I$
  • $(Y-T-C) + (T-G) = I$
  • $Private Saving + Public Saving = Investment$
  • $National Savings = Private Saving + Public Saving$
  • $National Savings = Investment$

Global Comparison of Savings Rates

• Savings rates vary significantly across countries.
• Example (2007, as percentage of GDP):
  • United States: 14%
  • United Kingdom: 15%
  • Italy: 19%
  • Canada: 20%
  • France: 24%
  • Germany: 24%
  • Japan: 29%

Exports vs. Imports

• Exports: Products made domestically and sold abroad.
• Imports: Products made abroad and sold domestically.
• Net exports (NX): The difference in value between exports and imports (used in the GDP equation).

Savings in an Open Economy

• Formula: $Y = C + I + G + NX$
• Relationship: $Private S + Public S = I + NX$
• $National Saving = I + NX$
• Implications of NX:
  • If NX is negative, then National Savings < I: Foreign savings finance domestic investment.
  • If NX is positive, then National Savings > I: Domestic savings finance investment abroad.

Three Kinds of Capital

• Physical Capital: Manufactured resources (buildings, machines).
• Human Capital: Improvement in labor force through education and knowledge.
• Financial Capital: Funds from savings available for investment spending.
• Positive Capital Inflow: Funds entering a country from abroad for investment.

Market for Loanable Funds

• Definition: A hypothetical market that illustrates the supply and demand for funds by lenders and borrowers.
• Interest Rate: The price of borrowing money, expressed as a percentage of the amount borrowed.

Rate of Return

• Definition: The profit earned on a project, expressed as a percentage of its cost.
• Decision: Projects are worth investing in if their rate of return exceeds the interest rate.

Loanable Funds Market Equilibrium

• Equilibrium is determined by the intersection of the supply and demand curves for loanable funds.
• Interest rate adjusts to equilibrate the quantity of loanable funds supplied and demanded.
• Only projects profitable at or above the equilibrium interest rate are funded.
• Lenders accept offers at or below the equilibrium interest rate.

Shifts in the Demand Curve for Loanable Funds

• Factors:
  • Changes in perceived business opportunities.
  • Changes in government borrowing.
    • Crowding out effect: Government budget deficits increase interest rates and reduce investment spending.

Shifts in the Supply Curve for Loanable Funds

• Factors:
  • Changes in private savings behavior.
  • Changes in net capital inflows.

Crowding Out of Private Investment

• An increase in the government deficit leads to a rise in equilibrium interest rates.
• This reduces private investment because some projects are no longer worth investing in at the higher interest rate.

Factors Affecting Interest Rates

• Changes in government policy.
• Technological innovations.
• Expectations about future inflation (most important factor).

Inflation and Interest Rates

• Changes in inflation expectations shift both the supply and demand for loanable funds.

Real vs. Nominal Interest Rates

• Real rate = nominal interest rate − inflation rate
• Loan contracts specify a nominal interest rate, but decisions are based on the real rate.

The Fisher Effect

• Definition: An increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.
• Implication: Changes in inflation expectations do not affect real interest rates or borrowing and lending.

Shifts in Supply of Loanable Funds

• Changes in private savings behavior: Rising home prices can reduce savings.
• Changes in capital inflows: Capital inflows can increase investment spending.

Government Budget

• Budget Balance: Difference between tax revenue and government spending.
• Government Budget Surplus: $Tax Revenue > Government Spending$ (Public Saving > 0).
• Government Budget Deficit: $Tax Revenue < Government Spending$ (Public Saving < 0).
• Financing Budget Deficits: Government borrowing.

Trade Balance

• Definition: The gap between a nation’s exports and imports (also called the current account balance).
• Trade deficits and surpluses can be good or bad depending on the economic conditions.

Investment Spending

• Investment Spending: Spending that increases the economy’s physical capital stock.
• Current Account Balance: Change in the value of a country’s net claims on the rest of the world.
• Capital Account Balance: Records the net sales of assets to foreigners.
• Relationship: $Current Account = - (Capital Account)$

Merchandise Trade Balance

• Definition: Balance of trade looking only at goods.
• Unilateral Transfers: Payments without direct goods or services in return.

Current Account

• Formula: $CA = Y + rB – C – G – I$ (where rB is interest earned on foreign assets).
• Savings Formula: $S = Y + rB – C – G$
• Saving-Investment Identity: $CA = S – I$
• Closed Economy: $CA = 0 = S – I$ à $S = I$

Investment Spending in an Open Economy

• Net capital inflow: Total inflow of funds into a country minus total outflow of funds.
  • Trade deficit ($imports > exports$) implies financial capital inflow (capital account surplus).

Trade Deficit and Capital Inflow

• Capital inflow: Money coming into a country via investment.
• Trade deficit: Money going out of a country.
• Balance: A country running a trade deficit receives capital inflows.
• Surplus: A country running a trade surplus invests it abroad.

National Saving and Investment Identity

• **Formula: $S + (M – X) = I + (G – T)$
• **S: Saving by individuals and firms
• **(M – X): imports – exports = trade deficit
• I: Private sector investment
• G: Government spending
• T: Taxes collected
• (G-T): Government budget deficit
• (T-G): Government budget surplus
• If G > T, the government demands financial capital. If T > G, the government supplies financial capital.

National Saving and Investment Identity Example

• Country A has a trade deficit of $200 billion, private savings of $500 billion, and private investment of $500 billion. What is Country A’s government budget deficit?
• $S + (M – X) = I + (G – T)$
• $500 + (-200) = 500 + (G-T)$
• $300 = 500 + (G-T)$
• $(G-T) = -200$

Trade Surplus

• In a trade surplus, the national saving and investment identity can be rewritten as:
• Trade Surplus = Private Domestic Saving + Public Saving – Domestic Investment
• $(X – M) = S + (T – G) – I$
• Domestic savings exceed domestic investment; extra financial capital is invested abroad.

Factors Causing Trade Deficits to Rise or Fall

• Domestic Investment – Private Domestic Savings – Public Domestic Savings = Trade Deficit
• $I – S – (T – G) = (M – X)$

Trade Balance and Recession

• In the short run, economic conditions (recession or upswing) affect trade imbalances.
• Recession: Trade deficit decreases, or trade surplus increases.
• Economic growth: Trade deficit increases, or trade surplus decreases.

Borrowing from Abroad

• Borrowing can be beneficial if the funds are invested wisely to increase economic growth.
• Examples: U.S. in the mid-1800s and South Korea in the 1970s.
• Borrowing can be detrimental if funds are not invested productively.
• Examples: Mexico, Brazil, and some African nations in the 1970s and 1980s.

Credit Default Swaps

• Definition: Insurance against a country’s default.
• Indicator: Higher price indicates a higher possibility of default.
• Examples:
  • UK: $28.21
  • US: $35.07
  • Mexico: $101.97
  • Brazil: $153.11
  • Egypt: $589.57

Is a Trade Deficit Always Bad?

• Not necessarily.
• 19th Century U.S.: Trade deficit facilitated foreign capital inflow used to finance infrastructure like railroads.

Is a Trade Surplus Always Good?

• Not necessarily.
• Japan: Decades of trade surplus but struggled with recession, low growth, and rising unemployment.
• High domestic savings contribute to the trade surplus.

Level of Trade vs. Trade Balance

• Level of trade: How much of a country's production it exports, measured as a percentage of GDP.
• Factors: Size of the economy, geographic location, and history of trade.

Levels of Trade Ranking

• Top 5 Countries (as percentage of GDP):
  • Luxembourg
  • Hong Kong
  • Singapore
  • San Marino
  • Dijibouti
• The United States (richest country) ranks 181/193.
• China (2nd richest country) ranks 157/193.
• Germany (3rd richest) ranks 64/193.

Merchandise Trade Balance

• Components of US Current Account
• The third component of the current account balance, labeled “income receipts and payments,” refers to money that U.S. financial investors received on their foreign investments (money flowing into the United States) and payments to foreign investors who had invested their funds here (money flowing out of the United States).

Current vs. Capital Account

• Flows of goods and services (top lines 1 & 3) show up in the current account.
• Flow of funds (top lines 2 & 4) show up in the capital account.
• Investment income (bottom lines 2 & 4) shows up in current account.
• Investment to the rest of the world or into the home country (bottom lines 1 & 3) show up in the capital account.

Exercise 1

• Explain why an decrease in the government budget deficit could lead to an increase in investment by firms.

Exercise 2

• Suppose that because of a rising price level, consumer starts carrying more of their wealth as cash, in order to carry out transactions, and thus are less willing to put their wealth into other assets -such as stocks or bonds. Depict the effect this will have on the market for loanable funds, and explain what will happen to both interest rates and investment.

Exercise 3

• Suppose the market for loanable funds is current in equilibrium, with no (zero) capital inflows or capital outflows.
  • (a) Using a supply and demand diagram, depict this situation.
  • (b) Suppose that there is a change in spending, and consumers start buying more imported goods than firms are exporting, so that there is now negative net exports. Depict the effect this will have on the market for loanable funds.

Exercise 4

• Explain why attracting capital inflows can be beneficial for long run growth.