slide 0 CHAPTER 3 National Income

Chapter 3

Continued

slide 1 CHAPTER 3 National Income

Notes

The equilibrium is stable

If r > r* S > I: More people want to save

relative to demand for funds: excess supply; r

decreases

If r < r* I > S: More demand for funds then

available: excess demand: r increases

slide 2 CHAPTER 3 National Income

Digression: Mastering models

To master a model, be sure to know:

1. Which of its variables are endogenous and

which are exogenous.

2. For each curve in the diagram, know

a. definition

b. intuition for slope

c. all the things that can shift the curve

3. Use the model to analyze the effects of each

item in 2c.

slide 3 CHAPTER 3 National Income

Mastering the loanable funds

model

Things that shift the saving curve

public saving

fiscal policy: changes in G or T

private saving

preferences

tax laws that affect saving

slide 4 CHAPTER 3 National Income

Changes in Saving: The Effects of Fiscal

Policy in the LONG RUN

So far we assumed G and T are fixed.

What happens if these variables change due to FP?

Increase in G (expansionary FP)

Recall:

Assuming that everything else in the economy remains the same, if

the government increases its share from the pie, somebody else

needs to get less (remember our long-run assumption):

________

)()( GrITYCY

slide 5 CHAPTER 3 National Income

Which group will get a smaller share?

Consumption remains the same because _____

Investment is the group that will get a smaller

share through a change in r.

When G , T – G = Public saving .

Total savings (= supply of loanable funds) r .

________

)()( GrITYCY

slide 6 CHAPTER 3 National Income

r

S, I

1S

I (r )

r1

I1

r2

I2

2S

slide 7 CHAPTER 3 National Income

Crowding Out

When r , I

We say government spending crowds out

investment

slide 8 CHAPTER 3 National Income

CASE STUDY:

The Financial Crisis of 2007

US government policies during the crisis:

increases in government spending: G > 0

tax cuts: T < 0

Both policies reduce national saving:

( )S Y C Y T G

G S T C S

slide 9 CHAPTER 3 National Income

CASE STUDY:

The Financial Crisis

r

S, I

1S

I (r )

r1

I1

r2 2. …which causes

the real interest

rate to rise…

I2

3. …which reduces

the level of

investment.

1. The increase in

the deficit

reduces saving…

2S

slide 10 CHAPTER 3 National Income

Notes

Why would the US Government engage in

policies that would reduce investment?

If we look at the data in ten years from now, we

may not necessarily see a decline in investment,

despite our model’s predictions. Why?

slide 11 CHAPTER 3 National Income

Mastering the loanable funds

model, continued

Things that shift the investment curve

some technological innovations

to take advantage of the innovation,

firms must buy new investment goods

tax laws that affect investment

investment tax credit

slide 12 CHAPTER 3 National Income

An increase in investment demand

An increase in desired investment…

r

S, I

I1

S

I2

r1

r2

…raises the

interest rate.

But the equilibrium

level of investment

cannot increase

because the

supply of loanable

funds is fixed.

slide 13 CHAPTER 3 National Income

Changing one of the assumptions

What if we make the following change in our model?

C = C(Y – T, r): Make consumption a function of real

interest.

Intuitively: as r , you might prefer to consume less

today and save more to earn interest income.

As r , C , (Y – C – G) increases: Upward sloping

savings- curve.

slide 14 CHAPTER 3 National Income

Saving and the interest rate

How would the results of an increase in

investment demand be different?

Would r rise as much?

Would the equilibrium value of I change?

slide 15 CHAPTER 3 National Income

An increase in investment demand

when saving depends on r

r

S, I

I(r)

( )S r

I(r)2

r1

r2

An increase in

investment demand

raises r,

which induces an

increase in the

quantity of saving,

which allows I

to increase.

I1 I2

slide 16 CHAPTER 3 National Income

End of chapter problem 7

Increase in T by $100, MPC = 0.6. What

happens to the following

a) Public Saving

b) Private Saving

c) National Saving

d) Investment

slide 17 CHAPTER 3 National Income

S (Public)=100

S (Private)=-40

S (National)=60

I=60

Graphically, this would be a rightward shift of the savings curve that lowers the real interest rate.

slide 18 CHAPTER 3 National Income

End of chapter problem 9

Y=C+I+G

Y=5000

G=1000

T=1000

C=250+0.75(Y-T)

I=1000-50r

slide 19 CHAPTER 3 National Income

S (Private)=750

S (Public)=0

S (National)=750

Equlibrium r =5%

slide 20 CHAPTER 3 National Income

End of Chapter problem 10

G= T

What happens to r and I?