Chapter 10: Savings and Investment

MATCHING UP SAVINGS AND INVESTMENT SPENDING

• Private Investment Spending:

  • In a modern economy, individuals and firms often finance physical capital using others’ money.

• Savings–Investment Spending Identity:

  • Total savings are equal to total investment spending in the economy as a whole.

THE SAVINGS–INVESTMENT SPENDING IDENTITY IN A CLOSED ECONOMY (1 of 4)

• Gross Domestic Product (GDP):

  • Represents total spending on domestically produced final goods and services.

  • Formula:
    $<br>GDP = C + I + G + X - IM<br>$

  • Variables:

  • C: Consumer spending

  • I: Investment spending

  • G: Government purchases of goods and services

  • X: Exports to other countries

  • IM: Imports from other countries

• In a closed economy, where exports (X) and imports (IM) equal zero:

  • $<br>GDP = C + I + G<br>$

• Total Income Equations:

  • Income can either be spent on consumption or saved:

  • Total income = Consumption spending + Savings:
    $<br>GDP = C + G + S<br>$

  • Total income = Consumption spending + Investment spending:
    $<br>GDP = C + G + I<br>$

THE SAVINGS–INVESTMENT SPENDING IDENTITY IN A CLOSED ECONOMY (2 of 4)

• Combining consumption equations gives:

  • $<br>C + G + S = C + G + I<br>$

• Rearranging yields:

  • $<br>S = I<br>$

  • Identifying that savings equal investment spending.

THE SAVINGS–INVESTMENT SPENDING IDENTITY IN A CLOSED ECONOMY (3 of 4)

• Savings Sources:

  • Both households and government can save.

  • National Savings:
    $<br>S<em>{National} = S</em>{Private} + S_{Public}<br>$

  • Budget Terms:

  • Budget Surplus: Excess of tax revenue over government spending.

  • Budget Deficit: Excess of government spending over tax revenue.

  • Government Borrowing: Funds borrowed by various levels of government in financial markets.

  • Budget Balance: Difference between tax revenue and government spending.

  • National Savings: Total savings generated within the economy.

THE SAVINGS–INVESTMENT SPENDING IDENTITY IN A CLOSED ECONOMY (4 of 4)

• Public (Government) Savings: $S_{Government} = T - TR - G$

  • Where:

  • T: taxes

  • TR: government transfers

  • Thus, $S<em>{National} = S</em>{Government} + S_{Private}$ represents that national savings equal investment spending.

THE SAVINGS–INVESTMENT SPENDING IDENTITY IN AN OPEN ECONOMY (1 of 2)

• In an open economy, goods and money can flow into and out of the country.

  • Countries can receive foreign savings financing domestic investment.

  • They can also generate outflows of domestic savings for investment in other countries.

• Net Foreign Investment (NFI):

  • Defined as total outflows minus inflows:
    $<br>NFI = ext{Total outflows} - ext{Total inflows}<br>$

  • If NFI is negative, it indicates more foreign investment in a country than domestic investment abroad.

  • For example:

  • In 2023, Canada’s NFI was −$11.3 billion, indicating more foreign investment than domestic.

THE SAVINGS–INVESTMENT SPENDING IDENTITY IN AN OPEN ECONOMY (2 of 2)

• If imports exceed exports, borrowing is required from foreigners.

  • Relationship:
    $<br>NFI = X - IM<br>$

• Rearranging gives:
  $<br>(GDP - C - G) = I + (X - IM)<br>$

• Since $(GDP - C - G)$ equals national savings, we write:
  $<br>S_{National} = I + NFI<br>$

THE SAVINGS–INVESTMENT SPENDING IDENTITY IN OPEN ECONOMIES, 2022

• Canadian investment financing involved private savings and capital inflow, offset by a government deficit.

• German investment was financed primarily through private savings and a slight budget surplus, countered by capital outflow.

LEARN BY DOING: PRACTICE QUESTION 1

• Net foreign investment is the .

  • a) net outflow of foreign funds plus domestic savings into an economy

  • b) outflow of domestic funds to other countries minus inflow of foreign funds into the country (correct)

  • c) inflow of foreign funds into the country minus outflow of domestic funds to other countries

  • d) total outflow of domestic funds to other countries plus net inflow of foreign funds into a country.

LEARN BY DOING: PRACTICE QUESTION 2

• If a country exports $50 million and imports $60 million, then it .

  • a) has a positive net foreign investment

  • b) lends funds to foreigners

  • c) has a negative net foreign investment (correct)

  • d) (a) and (b)

  • e) (b) and (c).

THE DOMESTIC MARKET FOR LOANABLE FUNDS (1 of 2)

• Loanable Funds Market:

  • A hypothetical market uniting savers and borrowers, facilitating loans for businesses needing capital.

  • Assumes a singular market for simplicity.

THE DOMESTIC MARKET FOR LOANABLE FUNDS (2 of 2)

• Price of Loans:

  • Represented by the nominal interest rate.

  • Recognizes many rates exist based on loan terms, risks, and customer profiles.

THE DOMESTIC DEMAND FOR LOANABLE FUNDS

• Interest Rate Role:

  • Represents the opportunity cost of investment spending.

  • Lower interest rates decrease appeal of saving, increase demand for loans leading to a downward sloping demand curve for loanable funds.

FOR INQUIRING MINDS: USING PRESENT VALUE

• Present Value Definition:

  • Amount needed today to achieve a specified future amount considering the interest rate.

• Formula for Present Value: $X imes (1 + r) = 1000 ightarrow X = rac{1000}{(1 + r)}$

  • Example scenario analyzing two investment projects with varying borrowing needs.

THE DOMESTIC SUPPLY OF LOANABLE FUNDS (1 of 2)

• Supply Curve Characteristics:

  • Represents savers’ willingness to lend funds.

THE DOMESTIC SUPPLY OF LOANABLE FUNDS (2 of 2)

• Slope of Supply Curve:

  • An upward slope is due to increased interest rewards prompting more savings.

THE EQUILIBRIUM INTEREST RATE (1 of 2)

• Equilibrium Condition:

  • Identified at the intersection of supply and demand curves for loanable funds.

THE EQUILIBRIUM INTEREST RATE (2 of 2)

• Equilibrium Interest Rate:

  • Rate where quantity of loanable funds supplied equals demanded.

  • Efficient match between savings and investments occurs.

SHIFTS OF THE DOMESTIC DEMAND FOR LOANABLE FUNDS

• Factors influencing shifts:

  • Perceived Business Opportunities:

  • Significant changes can shift demand curves right or left (e.g., tech bubbles).

  • Government Policy Changes:

  • Tax incentives can increase investment attractiveness, shifting demand right.

SHIFTS OF THE DOMESTIC SUPPLY OF LOANABLE FUNDS (1 of 2)

• Factors influencing supply shifts:

  • Saving Behavior:

  • Changes in personal savings lead to shifts (e.g., rise in personal saving rate).

  • Government Budget Balance:

  • Variations in surplus or deficit affect market conditions.

SHIFTS OF THE DOMESTIC SUPPLY OF LOANABLE FUNDS (2 of 2)

• Crowding Out:

  • Occurs when government borrowing raises interest rates, adversely affecting private investment.

  • May not occur during economic downturns as increased government spending can enhance savings.

A GLOBAL MARKET FOR LOANABLE FUNDS?

• Capital Flow Dynamics:

  • Low-interest rate countries experience inflow from high-interest regions, leading to interest rate equalization.

LOANABLE FUNDS IN A TWO-COUNTRY WORLD (1 of 2)

• Example of Canada (6%) vs. Britain (2%) demonstrates how capital flows from low to high-interest markets influenced by returns.

INTERNATIONAL CAPITAL FLOWS IN A TWO-COUNTRY WORLD (2 of 2)

• Outcome of capital inflows from Britain leading to interest rate equalization.

INFLATION AND INTEREST RATES

• Shifts in curves lead to interest rate fluctuations:

  • Influencing factors include government policy changes, tech advancements, and inflation expectations.

• Real Interest Rate:

  • Defined as:
    $<br>ext{Real Interest Rate} = ext{Nominal Interest Rate} - ext{Inflation Rate}<br>$

THE FISHER EFFECT

• Indicates that rising expected future inflation results in higher nominal rates without altering expected real rates.

ECONOMICS IN ACTION: SIXTY YEARS OF CANADIAN INTEREST RATES

• Historical interest rate changes reflect inflation changes and shifts in expected returns from investments.

LEARN BY DOING: DISCUSSION QUESTION 1

• In pairs, analyze the impacts of a rise in expected inflation from 3% to 6% on real and nominal interest rates and the equilibrium quantity of funds.