Chapter 26Chapter 13 Saving, Investment, and the Financial System WHATS !W I TH! THI"# !

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The Case Study on "The History of the U.S. Government Debt" has been updated. There is a new In the News box on "Finance in China."

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(y the end +, this chapter, st-dents sh+-ld -nderstand% some of the important financia institutions in the U.S. economy. how the financia system is re ated to !ey macroeconomic variab es. the mode of the supp y and demand for oanab e funds in financia mar!ets. how to use the oanab e"funds mode to ana y#e various $overnment po icies. how $overnment bud$et deficits affect the U.S. economy.

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Chapter %& is the second chapter in a four"chapter se'uence on the production of output in the on$ run. (n Chapter %)* we found that capita and abor are amon$ the primary determinants of output. For this reason* Chapter %& addresses the mar!et for savin$ and investment in capita * and Chapter %+ addresses the too s peop e and firms use when choosin$ capita pro,ects in which to invest. Chapter %- wi address the mar!et for abor. The purpose of Chapter %& is to show how savin$ and investment are coordinated by the oanab e funds mar!et. .ithin the framewor! of the oanab e funds mar!et* we are ab e to see the effects of taxes and $overnment deficits on savin$* investment* the accumu ation of capita * and u timate y* the $rowth rate of output.

) Chapter )/0Savin$* (nvestment* and the Financia System

1!2 /$I TS%

%. The U.S. financia system is made up of many types of financia institutions* such as the bond mar!et* the stoc! mar!et* ban!s* and mutua funds. 1 these institutions act to direct the resources of househo ds who want to save some of their income into the hands of househo ds and firms who want to borrow. ). 2ationa income accountin$ identities revea some important re ationships amon$ macroeconomic variab es. (n particu ar* for a c osed economy* nationa savin$ must e'ua investment. Financia institutions are the mechanism throu$h which the economy matches one person3s savin$ with another person3s investment. &. The interest rate is determined by the supp y and demand for oanab e funds. The supp y of oanab e funds comes from househo ds who want to save some of their income and end it out. The demand for oanab e funds comes from househo ds and firms who want to borrow for investment. To ana y#e how any po icy or event affects the interest rate* one must consider how it affects the supp y and demand for oanab e funds. +. 2ationa savin$ e'ua s private savin$ p us pub ic savin$. 1 $overnment bud$et deficit represents ne$ative pub ic savin$ and* therefore* reduces nationa savin$ and the supp y of oanab e funds avai ab e to finance investment. .hen a $overnment bud$et deficit crowds out investment* it reduces the $rowth of productivity and GD4.

CHA/T!" $0T&I !%
(. ((. Definition of ,inancial system% the gr+-p +, instit-ti+ns in the ec+n+my that help t+ match +ne pers+ns saving 3ith an+ther pers+ns investment . Financia (nstitutions in the U.S. 5conomy 1. Financia 6ar!ets %. ). Definition of ,inancial mar4ets% ,inancial instit-ti+ns thr+-gh 3hich savers can directly pr+vide ,-nds t+ 5+rr+3ers. The 7ond 6ar!et a. b. c. Definition of 5+nd% a certi,icate +, inde5tedness. 1 bond identifies the date of maturity and the rate of interest that wi be paid periodica y unti the oan matures. 8ne important characteristic that determines a bond3s va ue is its term. The term is the en$th of time unti the bond matures. 1 e se e'ua * on$"term bonds pay hi$her rates of interest than short"term bonds. 1nother important characteristic of a bond is its credit ris!* which is the probabi ity that the borrower wi fai to pay some of the interest or principa . 1 e se e'ua * the more ris!y a bond is* the hi$her its interest rate.

d.

Chapter )/0Savin$* (nvestment* and the Financia System & e. 1 third important characteristic of a bond is its tax treatment. For examp e* when state and oca $overnments issue bonds 9ca ed municipa bonds:* the interest income earned by the ho ders of these bonds is not taxed by the federa $overnment. This ma!es these bonds more attractive; thus* owerin$ the interest rate needed to entice peop e to buy them.

&.

The Stoc! 6ar!et a. b. c. Definition of st+c4% a claim t+ partial +3nership in a ,irm. The sa e of stoc! to raise money is ca ed equity finance; the sa e of bonds to raise money is ca ed debt finance. Stoc!s are so d on or$ani#ed stoc! exchan$es 9such as the 2ew <or! Stoc! 5xchan$e or 21SD1=: and the prices of stoc!s are determined by supp y and demand. The price of a stoc! $enera y ref ects the perception of a company3s future profitabi ity. 1 stock index is computed as an avera$e of a $roup of stoc! prices. FYI: How to Read the Newspapers Stock ab!es"provides an examp e of a stoc! tab e from the newspaper and then exp ains what each of the co umns means.

d. e. f.

7.

Financia (ntermediaries %. ). Definition of ,inancial intermediaries% ,inancial instit-ti+ns thr+-gh 3hich savers can indirectly pr+vide ,-nds t+ 5+rr+3ers. 7an!s a. b. The primary ro e of ban!s is to ta!e in deposits from peop e who want to save and then end them out to others who want to borrow. 7an!s pay depositors interest on their deposits and char$e borrowers a hi$her rate of interest to cover the costs of runnin$ the ban! and provide the ban! owners with some amount of profit. 7an!s a so p ay another important ro e in the economy by a owin$ individua s to use chec!in$ deposits as a medium of exchan$e.

c. &.

6utua Funds a. Definition of m-t-al ,-nd% an instit-ti+n that sells shares t+ the p-5lic and -ses the pr+ceeds t+ 5-y a p+rt,+li+ +, st+c4s and 5+nds. The primary advanta$e of a mutua fund is that it a ows individua s with sma amounts of money to diversify. 6utua funds ca ed >index funds? buy a of the stoc!s of a $iven stoc! index. These funds have $enera y performed better than funds with

b. c.

+ Chapter )/0Savin$* (nvestment* and the Financia System active fund mana$ers. This may be true because they trade stoc!s ess fre'uent y and they do not have to pay the sa aries of fund mana$ers. Activity 1 6 Create a /+rt,+li+ Type% T+pics% Class limitati+ns% Ta!e"home assi$nment Financia mar!ets .or!s in any si#e c ass

/-rp+se This assi$nment re'uires students to use the financia pa$es of the newspaper to create their own portfo io. 6any students are unfami iar with the basic e ements of stoc! and bond tab es. This assi$nment then as!s students to ana y#e e ements that wou d affect their portfo io. Instr-cti+ns 1s! the students to do the fo owin$ assi$nment. 6any possib e variations exist. (t can be worthwhi e to have students reeva uate their portfo io at the end of the semester. %. ). &. 1ssume you have @%AA*AAA in savin$s. Create a portfo io of securities worth @%AA*AAA. Decide what financia instruments you wou d i!e to use* then find their current prices in the newspaper. Ca cu ate your ho din$s of each security* based on current prices. .hat ob,ectives do you have for this portfo ioB .as it chosen to maximi#e short"term $ains* on$"term stabi ity* or some other ob,ectiveB 5xp ain how each of the fo owin$ economic events wou d affect the va ue of your portfo io. a. an increase or decrease in interest rates b. a recession c. rapid inf ation d. a depreciation of the U.S. do ar

C + m m + n An s 3 e r s a n d / + i n t s , + r # i s c - s s i + n 6ost students pic! a mix of common stoc!s* mutua funds* and bonds. Some choose fami iar* ow"ris!* but ow"yie din$ ban! accounts and certificates of deposit. 1 few may choose more sophisticated financia instruments. This can be used to introduce the tradeoff between ris! and return and the concept of the ris! premium. The impact of macroeconomic events on financia mar!ets usua y interests students. 4ortfo ios heavi y invested in cyc ica stoc!s wi $ive ow returns in the event of recession. 7onds and cash perform poor y with unanticipated inf ation. Forei$n"denominated assets may $ive hi$h returns if the do ar depreciates. (nterest rate chan$es can cause ar$e swin$s in the va ue of bond"heavy portfo ios.

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In the News: Finance in China %. (n the past* private firms have had a most no access to financia mar!ets in China.

Chapter )/0Savin$* (nvestment* and the Financia System ). This is an artic e from he New York i#es describin$ chan$es that are occurrin$ in the abi ity of private firms to se shares on the countryCs state"run stoc! mar!et.

D.

Summin$ Up %. ). There are many financia institutions in the U.S. economy. These institutions a serve the same $oa Dmovin$ funds from savers to borrowers.

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Savin$ and (nvestment in the 2ationa (ncome 1ccounts 6a!e sure that you wor! throu$h a of the a $ebraic steps here. Students wi not understand this materia if you s!ip steps. 1. Some (mportant (dentities %. Eemember that GD4 can be divided up into four componentsF consumption* investment* $overnment purchases* and net exports.

Y = C + I + G + NX
). .e wi assume that we are dea in$ with a c osed economy 9an economy that does not en$a$e in internationa trade or internationa borrowin$ and endin$:. This imp ies that GD4 can now be divided into on y three componentsF

Y = C + I + G
&. To iso ate investment* we can subtract C and $ from both sidesF

Y - C - G = I
+. The eft"hand side of this e'uation 9Y G C G $: is the tota income in the economy after payin$ for consumption and $overnment purchases. This amount is ca ed nationa savin$. Definition of nati+nal saving 7saving8% the t+tal inc+me in the ec+n+my that remains a,ter paying ,+r c+ns-mpti+n and g+vernment p-rchases . Substitutin$ savin$ 9S: into our identity $ives usF

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S = I
H. I. This e'uation te s us that savin$ e'ua s investment. Jet3s $o bac! to our definition of nationa savin$ once a$ainF

S = Y - C - G
K. .e can add taxes 9T: and subtract taxes 9T:F

/ Chapter )/0Savin$* (nvestment* and the Financia System

S = (Y - C - T ) + (T - G )
%A. The first part of this e'uation 9Y G 9 G $: is ca ed pub ic savin$. a. b. c. d. G C: is ca ed private savin$; the second part

Definition of private saving% the inc+me that h+-seh+lds have le,t a,ter paying ,+r ta9es and c+ns-mpti+n. Definition of p-5lic saving% the ta9 reven-e that the g+vernment has le,t a,ter paying ,+r its spending. Definition of 5-dget s-rpl-s% an e9cess +, ta9 reven-e +ver g+vernment spending. Definition of 5-dget de,icit% a sh+rt,all +, ta9 reven-e ,r+m g+vernment spending.

The important point to ma!e here is that with a $overnment bud$et deficit* pub ic savin$ is ne$ative and the pub ic sector is thus >dissavin$.? To ma!e up for this shortfa * it must $o to the oanab e funds mar!et and borrow the money. This wi reduce the supp y of oanab e funds avai ab e for investment. %%. The fact that S L I means that for the economy as a who e savin$ must be e'ua to investment. a. The bond mar!et* the stoc! mar!et* ban!s* mutua funds* and other financia mar!ets and institutions stand between the two sides of the S L I e'uation. These mar!ets and institutions ta!e in the nationCs savin$ and direct it to the nationCs investment.

b. 7.

The 6eanin$ of Savin$ and (nvestment %. (n macroeconomics* investment refers to the purchase of new capita * such as e'uipment or bui din$s.

<ou wi have to !eep remindin$ students what the term >investment? means to macroeconomists. 8utside of the economics profession* most peop e use the terms ). and >investin$? (f an individua spends ess >savin$? interchan$eab y. than he earns and uses the rest to buy stoc!s or mutua funds* economists ca this savin$. (M. The 6ar!et for Joanab e Funds 1. 7. Definition of mar4et ,+r l+ana5le ,-nds% the mar4et in 3hich th+se 3h+ 3ant t+ save s-pply ,-nds and th+se 3h+ 3ant t+ 5+rr+3 t+ invest demand ,-nds . Supp y and Demand for Joanab e Funds

Figure 1

Chapter )/0Savin$* (nvestment* and the Financia System H %. The supp y of oanab e funds comes from those who spend ess than they earn. The supp y can occur direct y throu$h the purchase of some stoc! or bonds or indirect y throu$h a financia intermediary. The demand for oans comes from househo ds and firms who wish to borrow funds to ma!e investments. Fami ies $enera y invest in new homes whi e firms may borrow to purchase new e'uipment or to bui d factories. The price of a oan is the interest rate.

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Students wi wonder which interest rate is the price of a oan. 5xp ain to them that interest rates in the economy do vary because of the thin$s discussed ear ier 9term* ris!* and tax treatment:* but that these interest rates tend to move to$ether when chan$es in the oanab e funds mar!et occur. Thus* it is appropriate to ta ! of one interest rate.

a. b.

1 e se e'ua * as the interest rate rises* the 'uantity of oanab e funds supp ied wi increase. 1 e se e'ua * as the interest rate rises* the 'uantity of oanab e funds demanded wi fa .

6a!e sure that you spend time discussin$ why the demand for oanab e funds is downward s opin$ and why the supp y of oanab e funds is upward s opin$. (t is important for students to understand the re ationships between the interest rate* savin$* and investment. +. 1t e'ui ibrium* the 'uantity of funds demanded is e'ua to the 'uantity of funds supp ied.

I Chapter )/0Savin$* (nvestment* and the Financia System

a.

(f the interest rate in the mar!et is $reater than the e'ui ibrium rate* the 'uantity of funds demanded wou d be sma er than the 'uantity of funds supp ied. Jenders wou d compete for borrowers* drivin$ the interest rate down. (f the interest rate in the mar!et is ess than the e'ui ibrium rate* the 'uantity of funds demanded wou d be $reater than the 'uantity of funds supp ied. The shorta$e of oanab e funds wou d encoura$e enders to raise the interest rate they char$e.

b.

(t is a $ood idea to remind students that the supp y of oanab e funds comes from savin$ and the demand for oanab e funds comes from investment by puttin$ -. nextThe supp y and demand for oanab e funds on the curve rea 9rather than >9savin$:? to the supp y curve and >9investment:? nextdepends to the demand as shown above. nomina : interest rate because the rea rate ref ects the true return to savin$ and the true cost of borrowin$. .hen examinin$ the next three sections on different po icies* encoura$e students to fo ow the three"step process deve oped in Chapter +. First* determine which curve is affected. Then* decide which way it shifts to determine the effects on the e'ui ibrium interest rate and 'uantity of funds. C. 4o icy %F Savin$ (ncentives Figure 2 %. ). Savin$s rates in the United States are re ative y ow when compared with other countries such as Napan and Germany. Suppose that the $overnment chan$es the tax code to encoura$e $reater savin$. a. b. &. This wi cause an increase in savin$* shiftin$ the supp y of oanab e funds to the ri$ht. The e'ui ibrium interest rate wi fa and the e'ui ibrium 'uantity of funds wi rise.

Thus* the resu t of the new tax aws wou d be a decrease in the e'ui ibrium interest rate and $reater savin$ and investment.

Chapter )/0Savin$* (nvestment* and the Financia System K

(f you wou d i!e* now wou d be a $ood time to discuss the debate in Chapter )& 5.concernin$ 4o icy )F (nvestment whether the tax(ncentives aws shou d be reformed to encoura$e savin$. Figure 3

%.

Suppose instead that the $overnment passed a new aw owerin$ taxes for any firm bui din$ a new factory or buyin$ a new piece of e'uipment 9throu$h the use of an investment tax credit:. a. b. This wi cause an increase in investment* causin$ the demand for oanab e funds to shift to the ri$ht. The e'ui ibrium interest rate wi rise* and the e'ui ibrium 'uantity of funds wi increase as we .

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Thus* the resu t of the new tax aws wou d be an increase in the e'ui ibrium interest rate and $reater savin$ and investment.

4oint out that both 4o icy % 9a aw to increase savin$: and 4o icy ) 9a aw to increase investment: each ead to an increase in both savin$ and investment. The difference between these two po icies ies in their effects on the interest rate.

%A Chapter )/0Savin$* (nvestment* and the Financia System

F.

4o icy &F Government 7ud$et Deficits and Surp uses

Figure 4 %. ). 1 bud$et deficit occurs if the $overnment spends more than it receives in tax revenue. This imp ies that pub ic savin$ 9T G G: fa s which wi ower nationa savin$.

a.

The supp y of oanab e funds wi shift to the eft.

Chapter )/0Savin$* (nvestment* and the Financia System %% b. &. +. -. /. The e'ui ibrium interest rate wi rise* and the e'ui ibrium 'uantity of funds wi decrease.

.hen the interest rate rises* the 'uantity of funds demanded for investment purposes fa s. Definition of cr+3ding +-t% a decrease in investment that res-lts ,r+m g+vernment 5+rr+3ing. .hen the $overnment reduces nationa savin$ by runnin$ a bud$et deficit* the interest rate rises and investment fa s. Government bud$et surp uses wor! in the opposite way. The supp y of oanab e funds increases* the e'ui ibrium interest rate fa s* and investment rises.

2ow mi$ht be a $ood time to move to the section in Chapter )& concernin$ the debate on whether or not the $overnment shou d ba ance its bud$et. H. Case Study: he History of %&S& $o'ern#ent (ebt Figure 5 a. Fi$ure - shows the debt of the U.S. $overnment expressed as a percenta$e of GD4. (n recent years* $overnment debt has been about -A percent of GD4. Throu$hout history* the primary cause of f uctuations in $overnment debt has been wars. However* the U.S. debt a so increased substantia y durin$ the %KIAs when taxes were cut but $overnment spendin$ was not. 7y the ate %KKAs* the debt to GD4 ratio be$an dec inin$ due to bud$et surp uses. 1s of )AA)* the Con$ressiona 7ud$et 8ffice was pro,ectin$ that the debt"GD4 ratio wou d dec ine over the next decade to reach %- percent in )A%).

b.

c. d.

S$&0TI$ S T$ T!.T /"$(&!:S%

;-ic4 ;-i<<es %. 1 stoc! is a c aim to partia ownership in a firm. 1 bond is a certificate of indebtedness. They are different in numerous waysF 9%: a bond pays interest 9a fixed payment determined when the bond is issued:* whi e a stoc! pays dividends 9a share of the firm3s profits that can increase if the firm is more profitab e:; 9): a bond has a fixed time to maturity* whi e a stoc! never matures; and 9&: if a company that has issued both stoc! and bonds $oes ban!rupt* the bondho ders $et paid off before the stoc!ho ders* so stoc!s have $reater ris! and potentia y $reater return than bonds. Stoc! and bonds are simi ar in that both are financia instruments that are used by companies to raise money for investment* both are traded on exchan$es* both are sub,ect to credit ris!* and the returns to both are taxed 9usua y:. 4rivate savin$ is the amount of income that househo ds have eft after payin$ their taxes and payin$ for their consumption. 4ub ic savin$ is the amount of tax revenue that the $overnment has eft after payin$ for its spendin$. 2ationa savin$ is e'ua to the tota income in the economy

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%) Chapter )/0Savin$* (nvestment* and the Financia System that remains after payin$ for consumption and $overnment purchases. (nvestment is the purchase of new capita * such as e'uipment or bui din$s. These terms are re ated in two waysF 9%: 2ationa savin$ is the sum of pub ic savin$ and private savin$* by definition. 9): 2ationa savin$ e'ua s investment. &. (f more 1mericans adopted a > ive for today? approach to ife* they wou d spend more and save ess. This wou d shift the supp y curve to the eft in the mar!et for oanab e funds* causin$ the interest rate to rise. (n e'ui ibrium* there wou d be ess savin$ and investment* and a hi$her interest rate.

;-esti+ns ,+r "evie3 %. The financia systemCs ro e is to he p match one personCs savin$ with another personCs investment. Two mar!ets that are part of the financia system are the bond mar!et* throu$h which ar$e corporations* the federa $overnment* or state and oca $overnments borrow* and the stoc! mar!et* throu$h which corporations se ownership shares. Two financia intermediaries are ban!s* which ta!e in deposits and use the deposits to ma!e oans* and mutua funds* which se shares to the pub ic and use the proceeds to buy a portfo io of financia assets. (t is important for peop e who own stoc!s and bonds to diversify their ho din$s because then they wi have on y a sma sta!e in each asset* which reduces ris!. 6utua funds ma!e such diversification easy by a owin$ a sma investor to purchase parts of hundreds of different stoc!s and bonds. 2ationa savin$ is the amount of a nationCs income that is not spent on consumption or $overnment purchases. 4rivate savin$ is the amount of income that househo ds have eft after payin$ their taxes and payin$ for their consumption. 4ub ic savin$ is the amount of tax revenue that the $overnment has eft after payin$ for its spendin$. The three variab es are re ated because nationa savin$ e'ua s private savin$ p us pub ic savin$. (nvestment refers to the purchase of new capita * such as e'uipment or bui din$s. (t is e'ua to nationa savin$. 1 chan$e in the tax code that mi$ht increase private savin$ is the introduction of a consumption tax to rep ace the income tax. Since a consumption tax wou d not tax the returns to savin$* it wou d increase the supp y of oanab e funds* thus owerin$ interest rates and increasin$ investment. 1 $overnment bud$et deficit arises when the $overnment spends more than it receives in tax revenue. Since a $overnment bud$et deficit reduces nationa savin$* it raises interest rates* reduces private investment* and thus reduces economic $rowth.

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+. -.

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/r+5lems and Applicati+ns %. a. b. The bond of an eastern 5uropean $overnment wou d pay a hi$her interest rate than the bond of the U.S. $overnment because there wou d be a $reater ris! of defau t. 1 bond that repays the principa in )A)- wou d pay a hi$her interest rate than a bond that repays the principa in )AA- because it has a on$er term to maturity* so there is more ris! to the principa . 1 bond from a software company you run in your $ara$e wou d pay a hi$her interest rate than a bond from Coca"Co a because your software company has more credit ris!.

c.

Chapter )/0Savin$* (nvestment* and the Financia System %&

d.

1 bond issued by the federa $overnment wou d pay a hi$her interest rate than a bond issued by 2ew <or! state because an investor does not have to pay federa income tax on the bond from 2ew <or! state.

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6any answers are possib e. 4rice"earnin$s ratios vary. 1 hi$h price"earnin$s ratio mi$ht indicate either that peop e expect earnin$s to rise in the future or that the stoc! is overva ued. 1 ow price"earnin$s ratio mi$ht indicate either that peop e expect earnin$s to fa or that the stoc! is underva ued. The stoc! mar!et does have a socia purpose. Firms obtain funds for investment by issuin$ new stoc!. 4eop e are more i!e y to buy that stoc! because there are or$ani#ed stoc! mar!ets* so peop e !now that they can se their stoc! if they want to. Stoc! prices are viewed as harbin$ers of future dec ines in rea GD4 because peop e va ue stoc!s based on the expected future profitabi ity of the firm. (f stoc! prices fa * this must mean that investors expect a ower future profitabi ity for the firms. This means that we mi$ht expect output in these firms to dec ine as we . .hen the Eussian $overnment defau ted on its debt* investors perceived a hi$her chance of defau t 9than they had before: on simi ar bonds so d by other deve opin$ countries. Thus the supp y of oanab e funds shifted to the eft* as shown in Fi$ure %. The resu t was an increase in the interest rate.

&.

+.

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%+ Chapter )/0Savin$* (nvestment* and the Financia System

Fig-re 1 /. Companies encoura$e their emp oyees to ho d stoc! in the company because it $ives the emp oyees the incentive to care about the firm3s profits* not ,ust their own sa ary. Then* if emp oyees see waste or see areas in which the firm can improve* they wi ta!e actions that benefit the company because they !now the va ue of their stoc! wi rise as a resu t. 1nd it a so $ives emp oyees an additiona incentive to wor! hard* !nowin$ that if the firm does we * they wi profit. 7ut from an emp oyee3s point of view* ownin$ stoc! in the company for which she or he wor!s can be ris!y. The emp oyee3s wa$es or sa ary is a ready tied to how we the firm performs. (f the firm has troub e* the emp oyee cou d be aid off or have her or his sa ary reduced. (f the emp oyee owns stoc! in the firm* then there is a doub e whammy the emp oyee is unemp oyed or $ets a ower sa ary and the va ue of the stoc! fa s as we . So ownin$ stoc! in your own company is a very ris!y proposition. 6ost emp oyees wou d be better off diversifyin$ ownin$ stoc! or bonds in other companiesso their fortunes wou dn3t depend so much on the firm for which they wor!. H. To a macroeconomist* savin$ occurs when a person3s income exceeds his consumption* whi e investment occurs when a person or firm purchases new capita * such as a house or business e'uipment. a. b. c. d. I. .hen your fami y ta!es out a mort$a$e and buys a new house* that is investment* because it is a purchase of new capita . .hen you use your @)AA paychec! to buy stoc! in 1TOT* that is savin$* because your income of @)AA is not bein$ spent on consumption $oods. .hen your roommate earns @%AA and deposits it in her account at a ban!* that is savin$* because the money is not spent on consumption $oods. .hen you borrow @%*AAA from a ban! to buy a car to use in your pi##a"de ivery business* that is investment* because the car is a capita $ood. L %.-* Spri'ate L A.- L Y ) ) C* Spub!ic L A.) L ) $. ) C* then rearran$in$ $ives C L Y ) ) Spri'ate L I " %.- " A.- L /. Since Spub!ic L

Given that Y L I* Since Spri'ate L Y )

Chapter )/0Savin$* (nvestment* and the Financia System %) $* then rearran$in$ $ives $ L ) Spub!ic L %.- " A.) L %.&. Since S L nationa savin$ L Spri'ate P Spub!ic L A.- P A.) L A.H. Fina y* since I * investment L S* I * A.H. K. a. (f interest rates increase* the costs of borrowin$ money to bui d the factory become hi$her* so the returns from bui din$ the new p ant may not be sufficient to cover the costs. Thus* hi$her interest rates ma!e it ess i!e y that (nte wi bui d the new factory. 5ven if (nte uses its own funds to finance the factory* the rise in interest rates sti matters. There is an opportunity cost on the use of the funds. (nstead of investin$ in the factory* (nte cou d invest the money in the bond mar!et to earn the hi$her interest rate avai ab e there. (nte wi compare its potentia returns from bui din$ the factory to the potentia returns from the bond mar!et. So if interest rates rise* so that bond mar!et returns rise* (nte is a$ain ess i!e y to invest in the factory.

b.

Fig-re 2 %A. a. Fi$ure ) i ustrates the effect of the @)A bi ion increase in $overnment borrowin$. (nitia y* the supp y of oanab e funds is curve S%* the e'ui ibrium rea interest rate is i%* and the 'uantity of oanab e funds is +%. The increase in $overnment borrowin$ by @)A bi ion reduces the supp y of oanab e funds at each interest rate by @)A bi ion* so the new supp y curve* S)* is shown by a shift to the eft of S% by exact y @)A bi ion. 1s a resu t of the shift* the new e'ui ibrium rea interest rate is i). The interest rate has increased as a resu t of the increase in $overnment borrowin$. Since the interest rate has increased* investment and nationa savin$ dec ine and private savin$ increases. The increase in $overnment borrowin$ reduces pub ic savin$. From the fi$ure you can see that tota oanab e funds 9and thus both investment and nationa savin$: dec ine by ess than @)A bi ion* whi e pub ic savin$ dec ines by @)A bi ion and private savin$ rises by ess than @)A bi ion. The more e astic is the supp y of oanab e funds* the f atter the supp y curve wou d be* so the interest rate wou d rise by ess and thus nationa savin$ wou d fa by ess* as Fi$ure & shows.

b.

c.

%/ Chapter )/0Savin$* (nvestment* and the Financia System

Fig-re 3 d. The more e astic the demand for oanab e funds* the f atter the demand curve wou d be* so the interest rate wou d rise by ess and thus nationa savin$ wou d fa by more* as Fi$ure + shows.

Fig-re = e. (f househo ds be ieve that $reater $overnment borrowin$ today imp ies hi$her taxes to pay off the $overnment debt in the future* then peop e wi save more so they can pay the hi$her future taxes* so private savin$ wi increase* as wi the supp y of oanab e funds. This wi offset the reduction in pub ic savin$* thus reducin$ the amount by which the e'ui ibrium 'uantity of investment and nationa savin$ dec ine* and reducin$ the amount that the interest rate rises. (f the rise in private savin$ was exact y e'ua to the increase in $overnment borrowin$* there wou d be no shift in the nationa savin$ curve* so investment* nationa savin$* and the interest rate wou d a be unchan$ed. This is the case of Eicardian e'uiva ence.

Chapter )/0Savin$* (nvestment* and the Financia System %H

%%.

Since new computer techno o$y enab es firms to reduce inventory investment* the demand curve for oanab e funds shifts to the eft* as shown in Fi$ure -. 1s a resu t* the e'ui ibrium 'uantity of oanab e funds dec ines* as does the interest rate. The dec ine in the interest rate then increases investment in factories and e'uipment* but overa investment sti dec ines.

Fig-re >

%).

Fig-re 6 (f wor d savin$s dec ines at the same time wor d investment rises* the supp y curve of oanab e funds shifts to the eft and the demand curve shifts to the ri$ht. Fi$ure / i ustrates the resu t that the wor d interest rate wi rise* whi e the overa effect on the e'ui ibrium 'uantity of oanab e funds is ambi$uousit depends on how bi$ the shifts of the two curves are re ative to each other* and on their e asticities. a. (nvestment can be increased by reducin$ taxes on private savin$ or by reducin$ the $overnment bud$et deficit. 7ut reducin$ taxes on private savin$ has the effect of increasin$ the $overnment bud$et deficit* un ess some other taxes are increased or

%&.

%I Chapter )/0Savin$* (nvestment* and the Financia System $overnment spendin$ is reduced. So it is difficu t to en$a$e in both po icies at the same time. b. To !now which of these po icies wou d be a more effective way to raise investment* you wou d need to !nowF 9%: what the e asticity of private savin$ is with respect to the after" tax rea interest rate* since that wou d determine how much private savin$ wou d increase if you reduced taxes on savin$; 9): how private savin$ responds to chan$es in the $overnment bud$et deficit* since* for examp e* if Eicardian e'uiva ence ho ds* the dec ine in the $overnment bud$et deficit wou d be matched by an e'ua dec ine in private savin$* so nationa savin$ wou d not increase at a ; and 9&: how e astic investment is with respect to the interest rate* since if investment is 'uite ine astic* neither po icy wi have much of an impact on investment.