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Copyright © 2004 South-Western
Hypothetical Market Adjustment to Great Leap Forward
How would the GLF have worked in a market economy?
•Initiating event might have been
•Increased Govt expenditure for “defense”—promote steel production in remote locations
•Technology advance increasing profitability of small steel manufacturing, use of scrap steel, etc.
•Use the standard macro model to work through the impact of these initiating events.
Copyright © 2004 South-Western
SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS
• Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:
Y = C + I + G + NX (NFI)Y = C + I + G + NX (NFI)
Copyright © 2004 South-Western
Some Important Relationships
• Now, subtract C and G from both sides of the equation:
Y – C – G =I + NFIY – C – G =I + NFI
• The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).
Copyright © 2004 South-Western
Summary
• National saving, or saving, can be expressed:
S = I+NFIS = I+NFI
S = Y – C – G S = Y – C – G
S = (Y – T – C) + (T – G)= NFI + IS = (Y – T – C) + (T – G)= NFI + I
S = Private Saving + Public SavingS = Private Saving + Public Saving
Copyright © 2004 South-Western
The Market for Loanable Funds
S = I + NFI At the equilibrium interest rate, the amount that
people want to save plus what the government saves exactly balances the desired quantities of investment and net foreign investment.
Copyright © 2004 South-Western
The Market for Loanable Funds
Quantity ofLoanable Funds
RealInterest
Rate
Demand for loanable funds (for domestic investment and net foreign investment)
Supply of loanable funds(from national saving)
Equilibriumquantity
Equilibriumreal interest
rate
Copyright © 2004 South-Western
How Net Foreign Investment Depends on the Interest rate...
0Net Foreign Investment
Real Interest Rate
Net foreign investment is positive.
Net foreign investment is negative.
The Market for Foreign-Currency Exchange...
Quantity of Dollars Exchangedinto Foreign Currency
RealExchange
RateSupply of dollars
(from net foreign investment)
Demand for dollars(for net exports)
Equilibriumquantity
Equilibrium real
exchange rate
(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
Supply
Quantity of Dollars
Demand
Supply
Net ForeignInvestment
Net foreign investment, NFI
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
r1
E1
r1
The Real Equilibrium in an Open Economy
The Effects of Financing GLF with a Government Budget Deficit
r2 r2
E2
1. A budget deficit reduces the supply of loanable funds...
S2
B
(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
S1
Quantity of Dollars
Demand
S1S2
Net ForeignInvestment
NFI
5. …which causes the real exchange rate to appreciate.
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
3. ...which in turn reduces net foreign investment.
4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency…
r1
A
E1
r1
2. ...which increases the real interest...
(a) The Market for Loanable Funds (b) Net Foreign Investment (China)
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
Supply
Quantity of Dollars
Demand
Supply
Net ForeignInvestment
Net foreign investment, NFI
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
r1
E1
r1
An Increase in the Profitability of Backyard Steel Furnaces
D2
E2
r2
What Actually Happened
• Backyard steel production and other projects were not profitable.
• Therefore, it was necessary to finance them through government procurement.
• In an open economy, this wasteful government expenditure might (temporarily) have been financed by investment from abroad. This at least temporarily would have reduced starvation, but would have paved the way for a future financial crisis if the foreign debt couldn’t be repayed.
