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Chapter 7: Savings and Investment Objectives Determinants of saving, investment, and interest rates Effect of government budget deficits Effect of international borrowing and lending

Chapter 7: Savings and Investment

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Chapter 7: Savings and Investment. Objectives Determinants of saving, investment, and interest rates Effect of government budget deficits Effect of international borrowing and lending. Physical Capital vs. Financial Capital. Physical capital - PowerPoint PPT Presentation

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Page 1: Chapter 7:  Savings and Investment

Chapter 7: Savings and Investment

Objectives

• Determinants of saving, investment, and interest rates

• Effect of government budget deficits

• Effect of international borrowing and lending

Page 2: Chapter 7:  Savings and Investment
Page 3: Chapter 7:  Savings and Investment

Physical Capital vs. Financial Capital

Physical capital • Tools, instruments, machines, buildings, and other

items that have been produced in the past and that are used today to produce goods and services.

Financial capital • The funds that firms use to buy physical capital.

Page 4: Chapter 7:  Savings and Investment

Capital and Investment

Capital Stock (K)• Total amount of capital measured at a given point in

time.Gross investment (I)

• total amount spent on purchases of new capital and on replacing depreciated capital.

Depreciation (capital consumption allowance)• decrease in the quantity of capital that results from wear

and tear and obsolescence.Net investment (IN)

• change in the quantity of capital.• I - CCA

K(t) = K(t-1) + IN

Page 5: Chapter 7:  Savings and Investment

Wealth and Saving

Wealth (W)• the value of all the things that people own.

Saving (S)• the amount of income that is not paid in taxes or

spent on consumption goods and services. Wealth increases with

• Saving (S)• Capital gains (CG)

Wealth is decreased by capital losses or dissaving.W(t) = W(t-1)+S(t-1)+ CG(t-1)

Page 6: Chapter 7:  Savings and Investment

Markets for financial capital

Saving is the source of funds used to finance investment.

These funds are supplied and demanded in three types of financial markets:

• Loan markets• Bond markets• Stock markets

Page 7: Chapter 7:  Savings and Investment

Financial Institutions and markets

Financial institution

•a firm that that operates on both sides of the markets for financial capital. •borrower in one market and a lender in another.

Types of financial institutions (more on this later)• Investment banks• Commercial banks• Government-sponsored mortgage lenders• Pension funds• Insurance companies

Page 8: Chapter 7:  Savings and Investment

The Market for Loanable Funds

The market for loanable funds • the market in which households, firms,

governments, and financial institutions borrow and lend.

• The market influences– Saving and investment– Interest rates

Page 9: Chapter 7:  Savings and Investment

The Market for Loanable Funds

The market for loanable funds is the aggregate of all the individual financial markets.

Funds that Finance Investment

1. Household saving S

2. Government budget surplus (T -Tr – G)

3. Loans from the rest of the world (M – X)

Because Income Side of GDP = Expenditure Side of GDP

C + S + (T-Tr) = C + I + G + (X-M)

I = S + (T-Tr)-G + (M-X)

Page 10: Chapter 7:  Savings and Investment

The Market for Loanable Funds

Nominal interest rate • More specific name for “interest rate”• Not adjusted for effects of inflation• ($ of interest / $ of principal) per period of time

Real interest rate • nominal interest rate adjusted to remove the effects

of inflation on the purchasing power of money.• nominal interest rate minus the inflation rate.

Page 11: Chapter 7:  Savings and Investment

The Market for Loanable Funds

Demand for loanable funds

the relationship between the quantity of loanable funds demanded and the real interest rate, ceteris paribus.

Business investment is the main item that makes up the demand for loanable funds.

Page 12: Chapter 7:  Savings and Investment

The Market for Loanable Funds

Changes in the Demand for Loanable Funds

(a shift in the demand curve)

When expected profits rises, the demand for loanable funds rises

Tax policy can affect demand for loanable funds• Investment tax credit• Accelerated depreciation.

Page 13: Chapter 7:  Savings and Investment

The Supply of Loanable Funds• the relationship between the quantity of loanable

funds supplied and the real interest rate, ceteris paribus.

• Saving is the main item that makes up the supply of loanable funds.

The Market for Loanable Funds

Page 14: Chapter 7:  Savings and Investment

Supply of Loanable Funds

Page 15: Chapter 7:  Savings and Investment

The Market for Loanable Funds

Changes in the supply of loanable funds

• Temporary changes in disposable income• Expected future income• Wealth• Perceived default risk of borrowers

Page 16: Chapter 7:  Savings and Investment

The Market for Loanable Funds: Equilibrium

Page 17: Chapter 7:  Savings and Investment

• Assuming no government or international sector,

• SLF= Saving• DLF=Investment

• Analyze effects of each of the following on Saving, Investment, real interest rate.

• A technological advance that creates profitable investment opportunities.

• Households become more optimistic about future income growth.

• Government creates more tax incentives for business investment.

The Market for Loanable Funds

Page 18: Chapter 7:  Savings and Investment

Government in the Market for Loanable Funds

Government enters the loan market when it has a budget surplus or deficit.

• A government budget surplus increases the supply of funds

• A government budget deficit increases the demand for funds.

Page 19: Chapter 7:  Savings and Investment

Includes federal, state and local governments.

Page 20: Chapter 7:  Savings and Investment

Government Surplus in the Market for Loanable Funds

Page 21: Chapter 7:  Savings and Investment

Government Deficit in the Market for Loanable Funds

Page 22: Chapter 7:  Savings and Investment

An increase in the government budget deficit will lead to ____ interest rates and ____ private investment

High

er; less

High

er; more

Lower;

less

Lower;

more

0% 0%0%0%

1. Higher; less

2. Higher; more

3. Lower; less

4. Lower; more

Countdown

10

Page 23: Chapter 7:  Savings and Investment

Government in the Market for Loanable Funds: Ricardo-Barro Effect

Page 24: Chapter 7:  Savings and Investment

The Global Loanable Funds Market

• The loanable funds market is global, not national.

• Financial capital is mobile: It moves to the best advantage of lenders and borrowers.

• Because lenders are free to seek the highest real interest rate and borrowers are free to seek the lowest real interest rate, the loanable funds market is a single, integrated, global market.

• Funds flow into the country in which the real interest rate is highest and out of the country in which the real interest rate is lowest.

Page 25: Chapter 7:  Savings and Investment

The Global Loanable Funds Market

International Borrowing and Lending

If a country’s net exports are negative, • Country is a net borrower• quantity of loanable funds in that country is greater

than national saving. If a country’s net exports are positive,

• the country is a net lender• the quantity of loanable funds in that country is less

than national saving.

Page 26: Chapter 7:  Savings and Investment
Page 27: Chapter 7:  Savings and Investment

0100200300

400500600700800900

11/1/2010

China, Mainland

Japan

United Kingdom

Oil Exporters

Brazil

Carib Bnkng Ctrs

Hong Kong

Canada

Taiwan

Russia

Switzerland

All Other

Foreign Holdings of U.S. Government Bonds (Billions of $)

Total Foreign Holdings = $4,347 b.

Page 28: Chapter 7:  Savings and Investment

The Global Loanable Funds Market

X-M<0(e.g. U.S. today)

X-M>0(e.g. China today)