Week 4

WEEK 4: Chapter 10 – Savings, Investment Spending and the Financial System

Overview

• Topics Covered:

  • The relationship between savings and investment spending in closed and open economies.

  • Introduction to the market for loanable funds.

  • Factors influencing demand and supply of loanable funds.

  • Determination of the interest rate in the loanable funds market.

Matching Up Savings and Investment Spending

• Importance of Capital:

  • Physical and human capital are crucial for long-run economic growth.

  • Human capital is supplied largely by government through public education in Canada.

  • Physical capital, besides infrastructure, is mainly generated through private investment spending.

• Savings-Investment Spending Identity:

  • Investment must equal savings:

    • Investment = Savings

    • Demand for Loanable Funds = Supply of Loanable Funds

The Savings-Investment Spending Identity in a Closed Economy

• Definition:

  • Closed Economy: No international trade (NX = 0, X = 0, IM = 0).

• National Income Identity:

  • GDP = Total Income (Y) = C + I + G

  • Total income is the equivalent of total spending by all economic sectors.

• Total Income Breakdown:

  • Total income can be categorized into consumption spending and savings.

  • National Savings (S_National):

    • Definition: Output not used for consumption = S_National = Y - C - G

    • Origins of National Savings:

      1. Private Savings (S_Private):

         • Savings of households

         • S_Private = (Y - T + TR) - C

      2. Public Savings (S_Public):

         • Savings by all government levels

         • S_Public = T - TR - G = Government Budget Balance (GBB)

Public Savings

• Calculation of Public Savings (SPublic):

  • SPublic = Taxes (T) - Transfers (TR) - Government Spending (G)

  • Conditions:

    • Budget Surplus: If (T - TR - G) > 0

    • Budget Deficit: If (T - TR - G) < 0

    • Balanced Budget: If (T - TR - G) = 0

• Proof of Savings Identity:

  • S_National = S_Private + S_Public

  • Verification: Y - C - G = I

The Savings-Investment Spending Identity in an Open Economy

• Open Economy Definition:

  • Engages in international trade, with capital inflows and outflows.

• Capital Movement:

  • Outflows: Purchase of foreign assets

  • Inflows: Foreign purchases of domestic assets

  • Net Foreign Investment (NFI):

    • NFI = Purchases of foreign assets - Sales of domestic assets

• Net Exports (NX):

  • NFI must equal to NX; they are interconnected.

  • Example: Trade Surplus → Lending to the rest of the world.

Loanable Funds Market

Overview

• Assumptions:

  • One type of loan and one interest rate in the economy.

  • The market aligns savers (lending) with borrowers (investing).

• Demand for Loanable Funds:

  • Comes from the need of firms and households for investment.

  • Only projects with positive NPV undertaken.

  • Interest Rate reflects opportunity costs.

Net Present Value (NPV)

• Formula: NPV = (Present Value of Returns) - (Present Value of Costs)

• Example of NPV Calculation:

  • For an investment project costing $100 with a return of $120 in 3 years:

    • Evaluate feasibility based on interest rates.

Relationship Between Interest Rate and Investment

• Observation:

  • Higher interest rates decrease desirability of investment.

  • There is an inverse relationship between interest rates and investment spending.

Supply of Loanable Funds

• Source:

  • Comes from national savings.

• Positive Relationship:

  • Higher interest rates lead to increased savings, hence higher supply of loanable funds.

Equilibrium Interest Rate

• Market Equilibrium:

  • Demand for loanable funds = Supply of loanable funds.

  • Determines equilibrium interest rates and quantity of loanable funds.

Factors Shifting Demand and Supply of Loanable Funds

Domestic Demand Shifts

• Factors affecting investment other than interest rates shift demand curve right.

  • Business Opportunities:

  • Government Policies:

Domestic Supply Shifts

• Factors affecting national savings shift supply curve.

  • Private Savings Behavior Changes:

  • Government Budget Changes:

Case Studies

Case 1: Investment Subsidy

• Decrease in investment cost leads to increased demand for loanable funds.

Case 2: Increased Government Spending

• Leads to reduced national savings and decreased supply of loanable funds, impacting interest rates.

Case 3: Equilibrium Calculation Example

• Numerical examples demonstrating shifts in demand/supply and calculating new equilibrium.

Case 4: Inflation and Interest Rates

• Real Interest Rate Focus:

• Effect of expected inflation on loanable funds market.

Conclusion

• Understanding the relationship between savings, investment, and interest rates is crucial for economic policy and financial decision-making.