Savings, Investment Spending, and the Financial …s3.amazonaws.com/zanran_storage/bcs.worthpublishers.com/...Solution Solution S-129 chapter: Savings, Investment Spending, and the

Solution

Solution

S-129

chapter:

Savings, Investment Spending, and theFinancial System

1. Given the following information about the closed economy of Brittania, what is thelevel of investment spending and private savings, and what is the budget balance?What is the relationship among the three? Is national savings equal to investmentspending? There are no government transfers.

GDP = $1,000 million T = $50 million

C = $850 million G = $100 million

1. In a closed economy, investment spending is equal to GDP minus consumer spendingminus government purchases of goods and services. In Brittania, investment spendingis $50 million:

I = GDP − C − G

I = $1,000 million − $850 million − $100 million = $50 million

Private savings is equal to disposable income (income net of taxes—and recall thatthere are no government transfers) minus consumer spending. In Brittania, privatesavings is $100 million:

Private savings = GDP − T − C = $1,000 million − $50 million − $850 million =$100 million

The budget balance is equal to tax revenue minus government purchases of goods andservices. In Brittania, the government is running a budget deficit of $50 million:

Budget balance = T − G = $50 million − $100 million = −$50 million

National savings is the sum of private savings and the budget balance; that is, it is$100 million − $50 million = $50 million. So investment spending does equal nation-al savings.

2. Given the following information about the open economy of Regalia, what is the levelof investment spending and private savings, and what are the budget balance and capi-tal inflow? What is the relationship among the four? There are no government trans-fers. (Hint: capital inflow = the value of imports (IM) minus the value of exports (X).)

GDP = $1,000 million G = $100 million

C = $850 million X = $100 million

T = $50 million IM = $125 million

2. In an economy with capital inflows or outflows, investment spending is equal to GDPminus consumer spending minus government purchases of goods and services pluscapital inflow, the value of imports minus the value of exports. In Regalia, investmentspending is $75 million:

I = (GDP − C − G) + (IM − X)

I = ($1,000 million − $850 million − $100 million) + ($125 million − $100 million)

I = $50 million + $25 million = $75 million

26 10ECO

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S129-S140_Krug2e_Macro_PS_Ch10.qxp 2/25/09 8:01 PM Page S-129

Solution

S-130 M A C R O E C O N O M I C S , C H A P T E R 1 0

E C O N O M I C S , C H A P T E R 2 6

Private savings and the budget balance are measured in the same way regardless ofwhether or not there are capital inflows or outflows. (Again, recall that there are nogovernment transfers.) In Regalia, private savings is $100 million and the budget bal-ance is −$50 million (that is, the government is running a deficit of $50 million):

Private savings = GDP − T − C = $1,000 million − $50 million − $850 million =$100 million

Budget balance = T − G = $50 million − $100 million = −$50 million

An economy will experience a positive capital inflow equal to the difference betweenimports and exports when imports exceed exports; it will experience a capital outflow(a negative capital inflow) equal to the difference between imports and exports whenexports exceed imports. Regalia has a positive capital inflow equal to $25 million:

Capital inflow = IM − X = $125 million − $100 million = $25 million

Investment spending must equal the sum of private savings, the budget balance, andthe capital inflow. In Regalia, we can see that this relationship holds among the four:

I = Private savings + Budget balance + Capital inflow = $75 million

3. The accompanying table shows the percentage of GDP accounted for by private sav-ings, investment spending, and capital inflow in the economies of Capsland andMarsalia. Capsland is currently experiencing a net capital inflow and Marsalia, a netcapital outflow. What is the budget balance (as a percentage of GDP) in both coun-tries? Are Capsland and Marsalia running a budget deficit or surplus?

3. In both countries, investment spending as a percentage of GDP must be equal to thesum of private savings, the budget balance, and capital inflow as a percentage of GDP.We can calculate the budget balance as investment spending minus the sum of privatesavings and capital inflow:

I = Private savings + Budget balance + Capital inflow

Budget balance = I − Private savings − Capital inflow

In Capsland, the budget balance is 5% of GDP; the government is running a budgetsurplus equal to 5% of GDP:

Budget balance = 20% − 10% − 5%

Budget balance = 5%

In Marsalia, the budget balance is −3% of GDP; the government is running a budgetdeficit equal to 3% of GDP:

Budget balance = 20% − 25% − (− 2%) = 20% − 25% + 2%

Budget balance = −3%

Capsland Marsalia

Investment spending as a percentage of GDP 20% 20%

Private savings as a percentage of GDP 10 25

Capital inflow as a percentage of GDP 5 −2


Solution

S AV I N G S, I N V E S T M E N T S P E N D I N G, A N D T H E F I N A N C I A L S Y S T E M S-131

4. Assume the economy is open to capital inflows and that capital inflows equalsimports (IM) minus exports (X). Answer each of the following questions.

a. X = $125 millionIM = $80 millionBudget balance = −$200 millionI = $350 millionCalculate private savings.

b. X = $85 millionIM = $135 millionBudget balance = $100 millionPrivate savings = $250 millionCalculate I.

c. X = $60 millionIM = $95 millionPrivate savings = $325 millionI = $300 millionCalculate the budget balance

d. Private savings = $325 millionI = $400 millionBudget balance = $10 millionCalculate IM − X.

4. According to the savings–investment spending identity in an economy open to capitalflows from abroad, the following must hold: I = Private savings + Budget balance +(IM − X). We use this to solve for the missing variable in each problem.

a. $350 million = Private savings − $200 million + ($80 million − $125 million)

So, private savings = $595 million

b. I = $250 million + $100 million + ($135 million − $85 million)

So, I = $400 million

c. $300 million = $325 million + Budget balance + ($95 million − $60 million)

So, the budget balance = −$60 million

d. $400 million = $325 million + $10 million + (IM − X)

So, capital inflow (IM − X) = $65 million

5. The accompanying table, taken from the National Income and Product Accounts Tables,shows the various components of U.S. GDP in 2006 and 2007 in billions of dollars.

Gross Government Government Net governmentdomestic Private Gross domestic purchases of savings (budget taxes after product consumption investment goods and services balance) transfers

Year (billions of dollars)

2006 $13,194.7 $9,224.5 $2,643.0 $2,089.3 −$195.4 ?

2007 13,841.3 9,734.2 2,593.3 2,221.9 ? $1,989.5

a. Complete the table by filling in the missing figures.

b. Calculate taxes (after transfers) as a percentage of GDP.

c. Calculate national savings and private savings.


Solution5. a. Because savings by the government is equal to the difference between the tax rev-enue that it collects (after transfers) and current government expenditure on con-sumption, the table can be completed as shown below.

b. In 2006, taxes (after transfers) as a percentage of GDP were 14.35%, and in 2007,14.37%. This can be found by dividing taxes (after transfers) by GDP.

c. National and private savings for 2006 and 2007 are listed in the accompanyingtable. National savings is equal to GDP minus consumption expenditures. Becauseconsumption expenditures must include both government purchases and privateconsumption, national savings = GDP − C − G. Private savings = national savingsminus the budget balance.

6. Use the market for loanable funds shown in the accompanying diagram to explainwhat happens to private savings, private investment spending, and the rate of interestif the following events occur. Assume that there are no capital inflows or outflows.

a. The government reduces the size of its deficit to zero.

b. At any given interest rate, consumers decide to save more. Assume the budget bal-ance is zero.

c. At any given interest rate, businesses become very optimistic about the future prof-itability of investment spending. Assume the budget balance is zero.

D

E

S Interest rate

r1

Quantity of loanable funds Q1

Year National savings Private savings

(billions of dollars)

2006 $1,880.9 $2,076.3

2007 1,885.2 2,117.6

Government Government NetGross Gross purchases savings government

domestic Private domestic of goods (budget taxes afterYear product consumption investment and services balance) transfers

(billions of dollars)

2006 $13,194.7 $9,224.5 $2,643.0 $2,089.3 −$195.4 $1,893.9

2007 13,841.3 9,734.2 2,593.3 2,221.9 −232.4 1,989.5




Solution6. a. If the government reduces its deficit to zero, there will be a decrease in the demandfor loanable funds, from D1 to D2, equal to the reduction in the size of the deficit.In the accompanying figure, the amount Q1 − Q3 represents the amount by whichthe government decreases its deficit. In response to the decrease in demand, theinterest rate falls from r1 to r2. This fall in interest rates will increase private invest-ment spending from Q3 to Q2 and decrease private savings from Q1 to Q2.

b. If consumers decide to save more, there will be an increase in the supply of loan-able funds. In the accompanying figure, this is represented by the rightward shift ofthe supply curve from S1 to S2. The increase in the supply of loanable funds reducesthe equilibrium interest rate from r1 to r2. In response to the lower interest rate,private investment spending will rise from Q1 to Q2.

c. Higher investment spending at any given interest rate leads to an increase in thedemand for loanable funds. In the accompanying figure, the increase in thedemand for loanable funds shifts the demand curve from D1 to D2 and raises theequilibrium interest rate from r1 to r2. In response to the higher interest rate, private savings will rise from Q1 to Q2.

Interest rate

r1

r2

Quantity of loanable funds Q2 Q1

E1

D1

S

D2

E2

Interest rate

r1

r2

Quantity of loanable funds Q2 Q1

E1

S1S2

E2

D

S Interest

rate

r1

r2

Quantity of loanable funds Q1 Q2 Q3

E1

E2

D1D2

Fall in government borrowing



Solution

7. The government is running a budget balance of zero when it decides to increase edu-cation spending by $200 billion and finance the spending by selling bonds. Theaccompanying diagram shows the market for loanable funds before the governmentsells the bonds. Assume that there are no capital inflows or outflows. How will theequilibrium interest rate and the equilibrium quantity of loanable funds change? Isthere any crowding out in the market?

7. The $200 billion in government borrowing will increase the demand for loanablefunds from D1 to D2 as shown in the accompanying diagram. The equilibrium interestrate rises from 10% to 12%, and the equilibrium quantity of loanable funds increasesfrom $500 billion to $600 billion. The rise in the interest rate will lead to an increasein private savings of $100 billion, and private investment spending will fall by $100billion. Through the rise in the interest rate, the increase in government borrowingcrowded out $100 billion in private investment spending.

8. In 2006, Congress estimated that the cost of the Iraq War was approximately $100billion a year. Since the U.S. government was running a budget deficit at the time,assume that the war was financed by government borrowing, which increases thedemand for loanable funds without affecting supply. This question considers the likelyeffect of this government expenditure on the interest rate.

a. Draw typical demand (D1) and supply (S1) curves for loanable funds without thecost of the war accounted for. Label the vertical axis “Interest rate” and the hori-zontal axis “Quantity of loanable funds.” Label the equilibrium point (E1) and theequilibrium interest rate (r1).

$200 4000 600 800 1,000 1,200

24%222018161412108642

Interestrate

Quantity of loanable funds (billions of dollars)

S

D2D1

E2E1

$200 400 0 600 800 1,000 1,200

24% 22 20 18 16 14 12 10 8 6 4 2

Interest rate

Quantity of loanable funds (billions of dollars)

D

E

S




Solution

Solution

b. Now consider a new diagram with the cost of the war included in the analysis.Shift the demand curve in the appropriate direction. Label the new equilibriumpoint (E2) and the new equilibrium interest rate (r2).

c. How does the equilibrium interest rate change in response to government expendi-ture on the war? Explain.

8. a. The demand for loanable funds without government borrowing to finance the IraqWar is shown in the accompanying diagram.

b.

c. Government borrowing to finance the Iraq War raises the interest rate in equilibri-um because the supply of loanable funds remains constant but the demand rises.

9. Explain why equilibrium in the loanable funds market maximizes efficiency.

9. Equilibrium in the loanable funds market maximizes efficiency because it ensures thatinvestment spending projects with higher rates of return get funded before those withlower rates of return. At the same time, private savers with the lowest opportunitycost for their funds will have their offers of loans accepted before savers with higheropportunity costs of funds. So in equilibrium the projects with the highest rates ofreturn will be funded by savers with the lowest costs of lending. This makes it morelikely that lenders and borrowers will make mutually beneficial trades—trades thatmake society as a whole better off.

10. How would you respond to a friend who claims that the government should eliminateall purchases that are financed by borrowing because such borrowing crowds out pri-vate investment spending?

Interest rate

Quantity of loanable funds

E2

E1

S1

D2D1

$100 billion

r1

r2

Interest rate


E1

S1

D1

r1



Solution

Solution10. You might first acknowledge that when the government runs a budget deficit, there isan increase in the demand for loanable funds. The increase in demand raises interestrates and decreases private investment spending. This means that businesses will addless physical capital each year and productivity growth may be slower than it would beif the government had not borrowed to cover its deficit. However, you might thenexplain that some government purchases are necessary for economic growth.Government funds much of the infrastructure within which the economy operates(for example, the legal framework, the court system, and the communications net-work), and the government also invests in education, roads, and airports necessaryfor economic growth.

11. Boris Borrower and Lynn Lender agree that Lynn will lend Boris $10,000 and thatBoris will repay the $10,000 with interest in one year. They agree to a nominal inter-est rate of 8%, reflecting a real interest rate of 3% on the loan and a commonlyshared expected inflation rate of 5% over the next year.

a. If the inflation rate is actually 4% over the next year, how does that lower-than-expected inflation rate affect Boris and Lynn? Who is better off?

b. If the actual inflation rate is 7% over the next year, how does that affect Boris andLynn? Who is better off?

11. a. If the actual inflation rate is 4%, Lynn is better off and Boris is worse off. Boris hadexpected to pay, and Lynn had expected to receive, a real interest rate of 3%.However, with an actual inflation rate of 4%, an 8% nominal interest rate yields areal interest rate of 4% (8% − 4% = 4%). So, in real terms, Boris pays more, andLynn receives more, than was expected.

b. If the actual inflation rate is 7%, Boris is better off and Lynn is worse off. Boris hadexpected to pay, and Lynn had expected to receive, a real interest rate of 3%.However, with an actual inflation rate of 7%, an 8% nominal interest rate yields areal interest rate of 1% (8% − 7% = 1%). So, in real terms, Boris pays less, andLynn receives less, than was expected.

12. Using the accompanying diagram, explain what will happen to the market for loan-able funds when there is a fall of 2 percentage points in the expected future inflationrate. How will the change in the expected future inflation rate affect the equilibriumquantity of loanable funds?


Interest rate

Q1

S1

8%

0

D1

E1 r1




Solution

Solution12. In the accompanying diagram, the market for loanable funds is initially in equilibri-um at E1, with a nominal interest rate of 8%. A fall of 2 percentage points in theexpected future inflation rate leads, by the Fisher effect, to a fall of 2 percentagepoints in the nominal interest rate to 6%. The real interest rate and the equilibriumquantity of loanable funds remain unchanged. The change in expected inflation causes both a downward shift of the supply curve for loanable funds, from S1 to S2,and a downward shift of the demand curve for loanable funds, from D1 to D2.

13. The accompanying diagram shows data for the interest rate on 10-year eurozone gov-ernment bonds as reported by the European Central Bank and inflation for the euro-zone for 1996 through mid-2008. How would you describe the relationship betweenthe two? How does the pattern compare to that of the United States in Figure 26-8?

13. The interest rate and the inflation rate moved somewhat together (both moving up ordown) from the beginning of 1996 to the end of 2000. From 2001 to the beginning of2008, there doesn’t seem to be an obvious pattern. During 2008, they again seem tomove together. Their sharp rise in the late 1990s mirrors what happened in the UnitedStates during the high-technology boom, as shown in Figure 26-8. But the drop in the10-year euro bond rate from 2000 to 2004 was not as sharp as the fall in the 10-yearTreasury rate. The pattern is similar—but not identical—to that of the United Statesshown in Figure 26-8.

Year

10-year euro bondrate, eurozoneinflation rate

9%87654321

1996 2000 2004 200820021998 2006

Inflation rate

Interest rate

Interest rate


Q1

E2

E1 8%

6

0

S1

S2

D1

D2

r1

r2



Solution

Solution

14. Which of the following are examples of investment spending, investing in financialassets, or investing in physical assets?

a. Rupert Moneybucks buys 100 shares of existing Coca-Cola stock.

b. Rhonda Moviestar spends $10 million to buy a mansion built in the 1970s.

c. Ronald Basketballstar spends $10 million to build a new mansion with a view ofthe Pacific Ocean.

d. Rawlings builds a new plant to make catcher’s mitts.

e. Russia buys $100 million in U.S. government bonds.

14. a. When Rupert Moneybucks buys 100 shares of existing Coca-Cola stock, he isinvesting in a financial asset. He has a paper claim that entitles him to futureincome from Coca-Cola. It is not an example of investment spending because itdoes not add to the stock of physical capital in the economy.

b. When Rhonda Moviestar spends $10 million to buy a mansion built in the 1970s,she is investing in a physical asset; she has bought something that she has the rightto use or to dispose of as she wishes. It is not an example of investment spendingbecause it does not add to the stock of physical capital in the economy—the man-sion was pre-existing.

c. When Ronald Basketballstar spends $10 million to build a new mansion with aview of the Pacific Ocean, he has engaged in investment spending because he hasadded to the amount of housing in the economy.

d. When Rawlings builds a new plant to make catcher’s mitts, it has engaged ininvestment spending because it has added to the economy’s stock of physical capital.

e. When the government of Russia buys $100 million in U.S. government bonds, ithas invested in a financial asset. The Russian government has a paper claim on theUnited States that entitles it to future income. It is not an example of investmentspending because it does not add to the stock of physical capital in either economy.

15. Explain how a well-functioning financial system increases savings and investmentspending, holding the budget balance and any capital flows fixed.

15. A well-functioning financial system increases both the supply of loanable funds andthe demand for loanable funds in three ways. (1) It reduces the transaction costs ofmaking financial deals incurred by either lenders or borrowers. (2) It reduces the riskassociated with making investments or engaging in investment spending. (3) Byincreasing the liquidity of financial assets, it makes saving and the purchasing offinancial assets more attractive to potential lenders, which increases investmentspending.

16. What are the important types of financial intermediaries in the U.S. economy? Whatare the primary assets of these intermediaries, and how do they facilitate investmentspending and saving?




Solution

Solution16. Mutual funds, pension funds, life insurance companies, and banks are the mostimportant types of financial intermediaries in the U.S. economy. Mutual funds arecompanies that buy stocks of other companies (the mutual funds companies’ primaryassets) and resell shares of the portfolio composed of those stocks to individualinvestors. Pension funds are a type of mutual fund that hold financial assets of othercompanies (the pension funds’ primary assets) and sell shares to individual savers forretirement income. A life insurance company also holds financial assets (the life insur-ance company’s primary assets) and sells policies that guarantee a payment to a policy-holder’s beneficiary when the policyholder dies. A bank makes loans to individuals andcorporations (the bank’s primary assets) and accepts deposits from the public that arepayable on demand. By either reducing risk through diversification (mutual funds,pension funds), reducing risk through insurance (life insurance companies), loweringtransaction costs (mutual funds, pension funds), or providing liquidity (banks), thesefinancial intermediaries facilitate savings and investment spending.

17. Explain the effect on a company’s stock price today of the following events, otherthings held constant.

a. The interest rate on bonds falls.

b. Several companies in the same sector announce surprisingly slow sales.

c. A change in the tax law passed last year reduces this year’s profit.

d. The company unexpectedly announces that due to an accounting error, it must amendlast year’s accounting statement and reduce last year’s reported profit by $5 million. Italso announces that this change has no implications for future profits.

17. a. Because bonds are a substitute asset for stocks, this will lead to a rise in all stockprices, including this company’s stock price.

b. This will lead to an immediate fall in the company’s stock price because it is unex-pected information that communicates to investors that the company’s sector isdoing poorly, and so it is likely that the company will also experience slow salesand a lower-than-expected future profit.

c. This will have no effect on the company’s stock price today because the effect ofthe change in the tax law on this year’s profit would have been incorporated intothe company’s stock price when the tax law change was announced.

d. This will have no effect on the company’s stock price today because the stock priceis based on expectations about the future stock price, and this is unaffected bychanges in previous years’ profits.

18. Sallie Mae is a quasi-governmental agency that packages individual student loans intopools of loans and sells shares of these pools to investors as Sallie Mae bonds.

a. What is this process called? What effect will it have on investors compared to thesituations in which they could only buy and sell individual student loans?

b. What effect do you think Sallie Mae’s actions will have on the ability of students toget loans?

c. Suppose that a very severe recession hits and, as a consequence, many graduatingstudents cannot get jobs and default on their student loans. What effect will thishave on Sallie Mae bonds? Why is it likely that investors now believe Sallie Maebonds to be riskier than expected? What will be the effect on the availability of stu-dent loans?



Solution18. a. By pooling individual loans and selling shares of those pools as bonds, Sallie Maehas engaged in securitization. Because the likelihood that a default by one student isusually unrelated, or independent, from the likelihood of default by some otherstudent, buying a Sallie Mae bond provides greater diversification for an investorthan an individual student loan. It also provides liquidity because it can be boughtand sold like a typical bond.

b. With Sallie Mae bonds, investors will be more willing to supply funds for studentscompared to a situation in which only individual loans were available. As a result,students should be able to receive more loans at a lower interest rate.

c. Widespread defaults by students will result in losses for investors who hold SallieMae bonds. Investors will come to believe that due to the recession that the likeli-hood of defaults among students are no longer unrelated events and so are riskierthan they expected. As a result, there will be fewer investors willing to buy SallieMae bonds at any given interest rate. Students will find it harder to get loans andwill have to pay a higher interest rate on those they do get.




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Savings, Investment Spending, and the Financial …s3.amazonaws.com/zanran_storage/bcs.worthpublishers.com/...Solution Solution S-129 chapter: Savings, Investment Spending, and the