Macroeconomics CHAPTER 9 - Kevin Rasco - Curriculum …€¦ · 2 What you will learn in this...
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Macroeconomics CHAPTER 9 Savings, Investment Spending, and the Financial System PowerPoint® Slides by Can Erbil © 2006 Worth Publishers, all rights reserved
Transcript of Macroeconomics CHAPTER 9 - Kevin Rasco - Curriculum …€¦ · 2 What you will learn in this...
MacroeconomicsCHAPTER 9
Savings, Investment Spending, and the Financial System
PowerPoint®
Slides by Can Erbil
©
2006 Worth Publishers, all rights reserved
2
What you will learn in this chapter:
The relationship between savings and investment spending
About the loanable
funds market, which shows how savers are matched with borrowers
The purpose of the four principal types of assets: stocks, bonds, loans, and bank deposits
How financial intermediaries help investors achieve diversification
Some competing views of what determines stock prices and why stock market fluctuations can be a source of macroeconomic instability
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Matching Up Savings and Investment Spending
According to the savings–investment spending identity, savings and investment spending are always equal for the economy as a whole.
The budget surplus is the difference between tax revenue and government spending when tax revenue exceeds government spending.
The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue.
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Matching Up Savings and Investment Spending
The budget balance is the difference between tax revenue and government spending.
National savings, the sum of private savings plus the budget balance, is the total amount of savings generated within the economy.
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The Savings–Investment Spending Identity in a Closed Economy
In a closed economy: GDP = C + I + G
SPrivate
= GDP + TR −
T −
C
SGovernment
= T −
TR −
GNS = SPrivate
+ SGovernment
= (GDP + TR −
T −
C) + (T −
TR −
G)
= GDP −
C −
GHence, I = NSInvestment spending = National savings in a closed economy
Presenter
Presentation Notes
Recall: GDP = C + I + G + X − IM (1) But, in a closed economy, there are no exports or imports, so GDP = C + I + G(2) Rearranging (2) I = GDP − C − G(3) We know from Chapter 7 that private savings is equal to disposable income (household income, including government transfers, net of taxes) minus consumer spending: SPrivate = GDP + TR − T − C(4) The governments can save, too: SGovernment = T − TR − G(5) Putting (4) and (5) together we find national savings (NS): NS = SPrivate + SGovernment = (GDP + TR − T − C) + (T − TR − G) = GDP − C − G(6) The right-hand sides of (3) and (6) are identical. Hence, I = NS(7) Investment spending = National savings in a closed economy
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A Budget Surplus
Presenter
Presentation Notes
Total investment spending is assumed to be $500 billion, $400 billion of which is financed by private savings. The remaining $100 billion comes from the budget surplus.
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A Budget Deficit
Presenter
Presentation Notes
A budget deficit of $100 billion is represented by the area below the horizontal axis. The budget deficit has absorbed part of private savings, which must now be $200 billion greater than it had been—$600 billion—in order for total savings to provide $500 billion in investment spending for this economy.
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The Savings–Investment Spending Identity in an Open Economy
I = SPrivate
+ SGovernment
+ (IM −
X) = NS + KI
Investment spending = National savings + Capital inflow in an open economy
Presenter
Presentation Notes
An open economy is an economy in which goods and money can flow into and out of the country. Capital inflow is net inflow of funds into a country. KI = IM − X(8) Rearranging (1): I = (GDP − C − G) + (IM − X)(9) We can break (GDP − C − G) into private savings and the budget balance, yielding for an open economy: I = SPrivate + SGovernment + (IM − X) = NS + KI(10) Investment spending = National savings + Capital inflow in an open economy
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The Savings-Investment Spending Identity in Open Economies: the United States, 2003
Presenter
Presentation Notes
U.S. investment spending in 2003 (equal to 18.4% of GDP) was financed by private savings (18.2% of GDP) and capital inflows (4.8% of GDP), which were partially offset by a budget deficit (−4.6% of GDP).
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The Savings-Investment Spending Identity in Open Economies: Japan, 2003
Presenter
Presentation Notes
Japanese investment spending in 2003 was higher as a percent of GDP (24.2%). It was financed by a higher level of private savings as a percent of GDP (35.3%), which was offset by both a capital outflow (−3.2% of GDP) and a relatively high budget deficit (−7.9% of GDP).
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The Market for Loanable Funds
The loanable funds market is a hypothetical market that examines the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders.
The interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender to a borrower for the use of their savings for one year.
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The Demand for Loanable Funds
Presenter
Presentation Notes
The demand curve for loanable funds slopes downward: the lower the interest rate, the greater the quantity of loanable funds demanded. In this example, reducing the interest rate from 12% to 4% increases the quantity of loanable funds demanded from $150 billion to $450 billion.
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The Market for Loanable Funds
The rate of return of a project is the profit earned on the project expressed as a percentage of its cost.
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The Supply for Loanable Funds
Presenter
Presentation Notes
The supply curve for loanable funds slopes upward: the higher the interest rate, the greater the quantity of loanable funds supplied. In this example, increasing the interest rate from 4% to 12% increases the quantity of loanable funds supplied from $150 billion to $450 billion.
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Equilibrium in the Loanable Funds Market
Presenter
Presentation Notes
At the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Here the equilibrium interest rate is 8%, with $300 billion of funds lent and borrowed. Investment spending projects with a rate of return of 8% or higher receive financing; those with a lower rate of return do not. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted; those who demand a higher interest rate do not.
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Savings, Investment Spending, and Government Policy
Quantity of private loanable
funds demanded falls
Presenter
Presentation Notes
A government must borrow if it runs a deficit, and this borrowing adds to the total demand for loanable funds. As a result, the demand curve for loanable funds shifts rightward by the amount of the government borrowing and the equilibrium moves from E1 to E2. This leads to an increase in the equilibrium interest rate from r1 to r2 and crowding out: the increase in the interest rate reduces the private quantity of loanable funds demanded from Q1 to Q2, as shown by the movement up the demand curve D1.
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Increasing Private Savings
Presenter
Presentation Notes
Some economists have urged reforms in the tax system and adoption of other policies that would, they say, increase private savings but keep tax revenue unchanged. If they are correct, the effect would be to shift the supply curve of loanable funds to the right, leading to a reduction in the equilibrium interest rate and a larger quantity of funds lent and borrowed. Private investment spending in the economy would rise and so, ultimately, would long-run economic growth.
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The Financial System −
DefinitionsA household’s wealth is the value of its accumulated savings.
A financial asset is a paper claim that entitles the buyer to future income from the seller.
A physical asset is a claim on a tangible object that gives the owner the right to dispose of the object as he or she wishes.
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The Financial System −
DefinitionsA liability is a requirement to pay income in the future.
Transaction costs are the expenses of negotiating and executing a deal.
Financial risk is uncertainty about future outcomes that involve financial losses and gains.
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Risk-Averse Attitudes Toward Gain and Loss
Presenter
Presentation Notes
A comparison of panels (a) and (b) shows that differences in wealth lead to differences in attitudes toward risk. The typical person represented in panel (a) experiences a $1,000 loss as a much more significant hardship than the wealthy person represented in panel (b). This reflects the fact that wealthy individuals, although still risk averse, tend to be more tolerant of risk than individuals of modest means.
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The Financial System –
More
DefinitionsAn individual can engage in diversification by investing in
several different things so that the possible losses are independent events.
An asset is liquid if it can be quickly converted into cash.
An asset is illiquid if it cannot be quickly converted into cash.
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The Financial System –
More
DefinitionsThere are four main types of financial assets: loans, bonds,
stocks, and bank deposits.A loan is a lending agreement between a particular lender and a particular borrower.A bank deposit is a claim on a bank that obliges the bank to give the depositor his or her cash when demanded.
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Three Tasks of a Financial System
Reducing transaction costs─the cost of making a deal;
Reducing financial risk─uncertainty about future outcomes that involves financial gains and losses;
Providing liquid assets─assets that can be quickly converted into cash (in contrast to illiquid assets, which can’t).
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Financial Intermediaries
A financial intermediary is an institution that transforms the funds it gathers from many individuals into financial assets.
A mutual fund is a financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors.
A pension fund is a type of mutual fund that holds assets in order to provide retirement income to its members.
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Financial Intermediaries
A life insurance company sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies.
A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs ofborrowers.
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An Example of a Diversified Mutual Fund
Presenter
Presentation Notes
Source: State Street Global Advisors.
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Financial Fluctuations
Financial market fluctuations can be a source of macroeconomic instability.
The demand for stocks:
Stock prices are determined by supply and demand as well as the desirability of competing assets, like bonds: when the interest rate rises, stock prices generally fall and vice versa.
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Financial Fluctuations
Financial market fluctuations can be a source of macroeconomic instability.
Stock market expectations:
Expectations drive the supply of and demand for stocks: expectations of higher future prices push today’s stock prices higher and expectations of lower future prices drive them lower.
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Financial Fluctuations
One view of how expectations are formed is the efficient markets hypothesis, which holds that the prices of financial assets embody all publicly available information.
It implies that fluctuations are inherently unpredictable—they follow a random walk.
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Irrational Markets?
Many market participants and economists believe that, based on actual evidence, financial markets are not as rational as the efficient markets hypothesis claims.
Such evidence includes the fact that stock price fluctuations are too great to be driven by fundamentals alone.
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Stock Prices and Macroeconomics
How do macroeconomists and policy makers deal with the fact that stock prices fluctuate a lot and that these fluctuations can have important economic effects?
The short answer is that, for the most part, they adopt an open-minded but watchful attitude.
Policy makers assume neither that markets always behave rationally nor that they can outsmart them.
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The End of Chapter 9
coming attraction: Chapter 10:
Aggregate Supply and Aggregate Demand
