Topic 7 Saving and investment in a closed economy
Topic 7: Saving and Investment in a Closed Economy
7.1 Learning Objectives
Describe the role of financial markets in an economy.
Define the three types of money aggregates (M1, M2, and M3).
Distinguish between:
Private and public savings
Budget surplus and budget deficit
Analyze effects of different fiscal policies using the loanable funds market model in a closed economy.
Apply the Net Present Value formula to compare the value of investments over different time periods.
7.2 The Money Market
Decision Making:
Consume or save?
Opportunity cost of consumption and saving:
The cost of not consuming is the benefit that could have been received from consumption.
The cost of saving includes potential consumption forgone.
Value of Money:
Money represents tradeable value and choices.
Represents the value of an economic activity that is considered worthy.
7.3 Financial Markets and Institutions
Role:
Deal with financial assets and match savers with borrowers.
Primarily focus on the market for loanable funds.
7.4 Role of Financial Markets
Markets allocate goods based on price.
Financial markets facilitate transactions between savers and borrowers, affecting loans for individuals (e.g., mortgages), businesses (e.g., machinery), and governments.
Research Highlight:
2022 Nobel Prize in Economic Sciences focused on banks' roles as facilitators of loans, enhancing productive capital allocation.
7.5 Financial Assets and Liquidity
Define financial assets:
Tangible (Real Assets): Physical resources
Intangible (Claims): Represent ownership (e.g., stocks and bonds)
Categories:
Currency
Debt (government bonds, loans)
Equity (stocks)
Liquidity:
Cash/money is the most liquid asset; its value is maintained over time.
7.6 Forms of Money
Types:
Commodity or commodity-backed currency (e.g., metals)
Fiat currency (e.g., notes, coins)
Access Methods:
Transaction accounts via cheque or cards, savings accounts accessible through ATMs.
7.7 Monetary Aggregates
Money supply is defined as follows:
M1: Currency in circulation + checkable deposits + traveler's cheques
M2: M1 + savings deposits, time deposits under a threshold, money market accounts
M3: M2 + large time deposits and institutional money-market funds
7.8 The Circular-Flow Diagram
Describes the flow of income in an economy, highlighting interactions among firms, households, government, and labour.
Relationship:
GDP (Y) = Consumption (C) + Investment (I) + Government Expenditures (G) in a closed economy.
7.9 Saving Types
National Saving: Total income after consumption and government spending
Private Saving: Income after household expenses and taxes
Public Saving: Tax revenue remaining after government spending
7.10 Important Identities
From GDP:
Y – C – G = I
This represents national saving.
Saving Equals Investment (S = I): Relates to closed economies.
7.11 Budget Surplus and Deficit
Surplus: Occurs when tax revenue (T) is greater than government spending (G).
Public saving represented as T - G.
Deficit: Occurs when G exceeds T; represented as G - T.
7.12 Loanable Funds
Decisions to save and invest modeled through supply and demand in the loanable funds market.
Loanable Funds: Income saved and lent instead of consumed.
7.13 Supply and Demand for Loanable Funds
Supply from savers; demand from businesses and individuals seeking loans.
Equilibrium dictated by the real interest rate determined through these interactions.
7.14 Real Interest Rate
Defined as nominal interest rate adjusted for inflation: r = i - π.
Determines true borrowing cost and influences investment decisions.
7.15 Government Policies Affecting Saving and Investment
Fiscal Policies:
Taxes that impact household savings and consumption
Taxes and budget balances affecting public savings
7.16 Taxes and Saving
Lower taxes on interest income incentives increased savings and shifts supply curve of loanable funds to the right, leading to lower equilibrium interest rates and increased loanable funds.
7.17 Taxes and Investment
Investment tax credits increase debt demand, shifting the investment demand curve right, resulting in higher real interest rates and increased loanable funds.
7.18 Government Budget Deficits
Budget deficits reduce national saving, impacting the supply of loanable funds.
7.19 Crowding Out Effect
Government borrowing can crowd out private sector borrowing for capital investments due to increased interest rates.
7.20 Government Budget Surpluses
Surpluses increase loanable funds supply, reduce real interest rates, stimulating further investments.
7.21 Time Preference and Net Present Value
Consideration of investment returns over time necessitates converting future value into present value using interest rates for accurate financial planning.
7.22 Calculating Net Present Value
The future value (FV) formula: FV = CV x (1 + r)^N
Present value: CV = FV / (1 + r)^N
Similar structure for working with time value of money: dividing for present, multiplying for future.
7.23 Summary
Financial system includes markets and intermediaries.
Real interest rate impacts loanable funds supply and investment decision outcomes.
Equations highlight the relationship between saving and investment in the economy.
In the context of the Net Present Value (NPV) formula, each letter represents the following:
FV: Future Value - the amount of money expected to be received in the future.
CV: Current Value or Present Value - the value of the future cash flows in today's terms.
r: Interest Rate - the discount rate used to calculate the present value of future cash flows.
N: Number of periods - the number of time periods (years, months, etc.) until the future cash flow is received.
The formulas related to NPV are as follows:
Future Value: FV = CV x (1 + r)^N
Present Value: CV = FV / (1 + r)^N
These components allow for accurate financial planning by comparing the value of cash flows over time.