Week 4

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

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.

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

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)

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

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.

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.

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.

Observation:
- Higher interest rates decrease desirability of investment.
- There is an inverse relationship between interest rates and investment spending.

Source:
- Comes from national savings.
Positive Relationship:
- Higher interest rates lead to increased savings, hence higher supply of loanable funds.

Market Equilibrium:
- Demand for loanable funds = Supply of loanable funds.
- Determines equilibrium interest rates and quantity of loanable funds.

Factors affecting investment other than interest rates shift demand curve right.
- Business Opportunities:
- Government Policies:

Factors affecting national savings shift supply curve.
- Private Savings Behavior Changes:
- Government Budget Changes:

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

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

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