Chapter 13 (ME)

Why do economists study people’s savings and investment decisions?

  • Savings and investment are keys to increase living standards 

  • Savings

    • A vehicle for transferring purchasing power to the future 

  • Investment

    • Purchases of new capital (such as equipment or building), borrowing to finance those purchases 

National Income Account Identity

  • National Income Account Identity

    • Used to determine how important macroeconomic indicators are related to each other

    • 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋

  • An identity is an equation that must be true because of the way the variables in the equation are defined

    • It is useful because they clarify how different variables are related to one another

    • Closed economy - no trade 

  • Y = C + G + I

  • Y - C - G = C + G + I - C - G 

  • S = Y - C - G = I

  • (national saving)     S = I   

    • National saving is equal to investment in closed economy

Types of Savings

Private and Public Savings

  • Private saving = Y - T - C                       (T: Tax)

    • Leftover income households have after spending their money on C and paying taxes

  • Public saving = T - G

    • Leftover tax revenue the govt has after paying for all its spending (G)

Example 1 

__ = investment = 19,000 + 1,000 + 8,000 = 28,000

Last quarter in a closed economy GDP was 150,000. Expenditures on capital goods such as business equipment and structures was 19,000, inventory rose 1,000, and new construction of homes was 8,000.

Consumption was 85,000 and taxes were 32,000. What was public saving?

Y = C + I + G

  1. Public savings = T - G = 32,000 - G

  2. G ? G = Y - C - I

           = 150,000 - 85,000 - 28,000 = 37,000

  1. T - G = 32,000 - 37,000 = -5,000





a. -$4,000

b. -$6,000

c. -$14,000

d. -$5,000



Question 1

In a small closed economy investment is $20 billion and private saving is $15 billion.

What are public saving and national saving?

S = I in closed economy → national saving = $20 billion 

Y = C + I + G 

Public saving = T - G 

                      I = Y - C - G = $20  

Private saving = Y - T - C = $15

                               T - G = $5



a. $5 billion and $15 billion

b. -$5 billion and $15 billion

c. -$5 billion and $20 billion

d. $5 billion and $20 billion



The Government Budget

  • The government’s budget

    • How much money they are allowed to spend on purchasing in a given year

  • The government’s budget balance

    • Is determined by whether they spend more or less than they take in that year

  • The government’s “income” is tax revenue

    • When the government spends more than they collect in tax revenue, they run a budget deficit: G -T

Public saving < 0 → T - G < 0 → T < G

  • When the government spends less than they collect in tax revenue, they run a budget surplus:   T - G ** -(public saving)

Public saving > 0 → T - G > 0 → T > G




Y = C + I + G



I = Y - C - G 

I = 100 - 65 - 2

I = $33

S = $33 → National savings

 

2 - T = 3

T = -1 → Taxes: -$1 billion

Public saving: T-G

-1-2 = -3



Private savings: Y - C - T

100 - 65 - (-1) = 36



Indexation

  • Money illusion? 

    • When people see rising prices, they feel that they are worse off 

      • Just see “nominal $” terms 

Nominal Interest Rate vs Real Interest Rate

  • Nominal interest rate (nor corrected for inflation)

    • The rate of growth in the dollar value of a deposit or debt 

  • Real interest rate

    • The interest rate for inflation 

    • The rate of growth in the purchasing power of a deposit or debt 

  • Real interest rate = Nominal interest rate - inflation rate 

    • “Fisher Equation”

    • R = N - pi (inflation rate)

  • Ex: Deposit $1,000 for 1 year

    • N = 9%; pi = 3.5%

  • Compute the real interest rate

    • R = 9% - 3.5%

    • R = 5.5%

  • $1,000 + $1,000 x 0.09 = $1,000(1 + 0.09) = $1,090 in the next year 

  • $1,000 + $1,000 x 0.055 = $1,000(1+ 0.055) = $1,055 (the actual amount you earn)

    • Lose purchasing power!!



Nominal interest rate from 2020 to 2021 is 2.5%

  • GDP Deflator in 2020: 257

  • GDP Deflator in 2021: 261

What is the real interest rate from 2020 to 2021?

(261-257) / 257 x 100 = 1.5% = inflation rate



R = 2.5% - 1.6%

R = 0.9%



The Market for Loanable Funds

Matching Savings and Investments

  • For the economy as a whole in a closed economy: Savings = Investment

  • Our purpose is to explain how financial markets coordinate the economy’s saving and investment!

  • It helps us understand:

    • How government policies and other factors affect saving, investment, interest rate

Market for Loanable Funds

  • Loanable fund

    • Income that people have chosen to save and lend out, rather then use for their own consumption, and to the amount that investors have chosen to borrow to fund new investment projects 

    • Or, think as the flow of resources available to fund private investment

  • Assume: only 1 financial market called the market for loanable funds

    • All savers go to this market to deposit their saving

    • All borrowers (investors) go to this market to take out their loans

    • There is 1 interest rate (real) which is both the return to saving and the cost of borrowing 

      • The amount that lenders receive on their saving and the amount that borrowers pay for loans 

  • Supply of loanable funds

    • It comes from people who save extra income they want to save and lend out

    • Saving is the source of the supply of Loanable Funds

    • Households with extra income can lend it out and earn interest

  • Demand for loanable funds

    • It comes from households and firms who wish to borrow to make investments to purchase capital goods 

    • Investment is the source of the the demand for loanable funds

      • Firms borrow the funds they need to pay for new equipment, factories, etc

      • Household borrow the funds they need to purchase new houses 

  • In equilibrium

Demand and Supply Market for Loanable Funds

  • Demand for Loanable Funds is still governed by the Law of Demand

    • Price = real interest rate: what you have to pay to borrow the money

    • As the real interest rate increases, the quantity of loanable funds demanded decreases

    • Borrowing becomes more expensive so you demand fewer loans/dollars

  • Supply for Loanable Funds is still governed by the Law of Supply

    • Price = real interest rate: what you earn for letting other people borrow your money

    • As the real interest rate increases, the quantity of loanable funds supplied increases

    • Savings becomes more profitable so you save more dollars

How the Govt Policy Affect the Equilibrium 

Changes in Saving and Investment Behavior 

  • Policy shifts the supply or demand curve 

  • Determine the direction of the shift  

  • See how the equilibrium changes (initial equilibrium → new equilibrium)

Policy Choices: 1) Saving Incentives

  • Savings incentives are designed to encourage people to save more

    • Reduce taxes from interest income 

      • Reduce tax burden

  • Decreasing risk / financial safety nets

    • For certain types of savings, decreasing the risk or providing a financial “backstop” could increase S

    • Federal Deposit Insurance Corporation (FDIC) guarantees a certain amount of a person’s savings even if the bank fails

      • 1980-2008: covered $100,000

      • 2008-today: covers $250,000

  • The goal of savings incentives is to increase national savings