9 Capital Formation, Financial Markers and Money Supply

Question 1

Savings formula?

Answer 1

Current income - spending on Current needs

Question 2

Saving rate formula?

Answer 2

Saving / income

Question 3

Wealth formula?

Answer 3

Wealth refers to total value of all assets - liabilities

Includes tangibles assets and intangible assets, such as financial investments (stocks, bonds), intellectual property, and savings.

Question 4

What is flow value? What is stock value?

Answer 4

Flow value: measured over a period of time (income & saving)

Stock value: defined at a point in time (wealth & debt)

Question 5

Formula for change in wealth?

Answer 5

Change in wealth = Saving + Capital gains - Capital losses

Wealth changes when value of assets change

Question 6

National Savings formula?

Answer 6

National Savings (S) determines a country’s ability to invest in new capital goods (produce more output in future). Contributed by households, business and government savings

Assume NX = 0

S= Y - C - G
(GDP - Consumption - Government purchases)

S = Current Income (GDP or Y) - spending on Current needs
- Excludes all Investment spendings (future needs)

Same formula but diff approach^
S = private savings + public savings
S = (Y - T - C) + (T - G)
S = Y - C - G

Question 7

Private saving formula?

Answer 7

S private = Y - T - C

Private saving = AFTER-TAX INCOME - Consumption

Household’s total income (Y)

Private saving = Household + Business saving

Question 8

Formula for net taxes for private savings?

Answer 8

Net taxes (T) = Taxes - Transfers

Govt transfer payments increase household income
- made by govt without receiving any goods in return

Question 9

Business savings formula?

Answer 9

Revenue - operating costs - dividends to shareholders

Business savings can purchase new capital equipment - Investment

Question 10

Public saving formula?

Answer 10

S public = T - G

Public saving (by govt) is the amt of public sector’s income (net taxes T) not spent on current needs (G)

Question 11

What is government budget?

Answer 11

1. Balanced budget: govt spendings = net tax receipts
2. Govt budget SURPLUS: T - G (excess of govt net tax collections over spending). Occurs during expansion
3. Govt budget DEFICIT: public dissavings (want govt to spend more on us but we are unwilling to pay more taxes). Occurs during recession

Question 12

3 reasons for household saving? (private saving)

Answer 12

1. Life-cycle saving (retirement, buy house, children’s uni fees)
2. Precautionary saving (protection for losing jobs, medical emergency)
3. Bequest saving (inheritance)

Question 13

What are savings?

Answer 13

Financial assets that pay a return
- Saving and fixed deposits
- Bonds
- Stocks

real interest rate = nominal interest rate - rate of inflation

(high real interest rate - more returns)

Question 14

Reasons of low savings?

Answer 14

1. Generous safety measures
2. Mortgages with small/ no down payment
3. Confidence in prosperous future
4. Increasing value of stocks and growing home values
5. Readily available home equity loans
6. Demonstration effect and status goods (buy what others have also)

Question 15

What is investment?

Answer 15

The creation of new capital goods and housing (savings channeled to finance investments)

Cost-benefit principle
Cost: of using machine/capital
Benefit: value of marginal product of capital

Question 16

2 important costs in the Investment decision?

Answer 16

1. Price of capital goods
2. Real interest rates

(both increase - lead to decrease in investment)

Question 17

Value of marginal product of capital is its benefits. What do other costs include?

Answer 17

• Net of operating & maintenance expenses and of taxes on revenue generated

Increases benefits:
- Technical innovation
- Lower taxes
- Higher price of output

Question 18

What is supply of savings (S)? Upward or downward sloping?

Answer 18

Amt of savings that would occur at each real interest rate (r)

Upward sloping

Question 19

What is demand for investment (I)? Upward or downward sloping?

Answer 19

Amt of savings borrowed at each real interest rate

Downward sloping

Question 20

Financial market x-axis and y-axis?

Answer 20

(x) Saving and investment
(y) Real interest rate

Downward sloping (Investment - I)
Upward sloping (Savings - S)

Question 21

What is equilibrium interest rate?

Answer 21

Amt of saving = investment funds demanded (all investment comes from savings)

If r (real interest rate) above equilibrium: will have surplus of savings

Question 22

What happens to graph when technology improves?

Answer 22

Demand curve (Investment) shifts right

(New technology raises marginal productivity of capital)

• Higher interest rate
• Higher levels of savings and investment

Question 23

What happens to graph when govt budget deficit increases?

Answer 23

Supply curve (Savings) shift left

(National savings formed by private + public savings. Govt deficit reduce national savings)

• Higher interest rate
• Lower level of savings and investment

Private investment is hence crowded out - negative budget decision of govt discourages private investment

Question 24

How to increase national saving? 2 ways (have higher investment & growth rates)

Answer 24

1. Reduce govt budget deficit
2. Increase incentives for households (consumption tax, reduce taxes on investment income)

Higher national saving rate- greater investment in new capital goods - higher standard of living

Question 25

What are financial intermediaries?

Answer 25

Firms that extend credit to borrowers using funds raised from savers

Question 26

What are bonds? What does it consist of?

Answer 26

A legal promise to repay a debt

• Principal amount
• Maturation date
• Coupon payments (if u buy my bond, I will reward u w a certain amt every period)
• Coupon rate (interest rate applied to principal to determine coupon payments)

Question 27

What does coupon rate depend on? 3 factors

Answer 27

1. Bond’s term (longer, higher risk, higher coupon rate)
2. Issuer’s credit risk
3. Tax treatment for coupon payments (Government bond - safer - coupon bond not flexible - need lower coupon rate to attract people to buy
   Private bond - coupon payment more flexible)

Question 28

How to make bond more attractive compared to competitors?

Answer 28

Lower bond price

bond price x market interest rate = final payment (principal + coupon payment)

Lower bond price by how much? according to market interest rate, find final payment then work backwards to calc new bond price

Bond price & interest rates are inversely related (drops & increase, vice versa)

Question 29

What are stocks?

Answer 29

A claim to partial ownership of firm

2 reasons for buying company’s shares:

• Receive dividends (when company makes profit)
• Receive capital gains (selling next year at higher price)

Question 30

When will value of stock be higher?

Answer 30

Stock price x interest rate = selling price of stock + dividend

• Dividend higher
• Price of stock in future higher
• Interest rate LOWER

Question 31

What is risk premium?

Answer 31

Rate of return investors require to hold RISKY assets - rate of return on safe assets

Buying shares riskier than bonds

When calculating, use risk premium % not market interest rate %

Question 32

Risk aversion (increase/decrease) the return required of a risky stock and (increase/ lower) selling price

Answer 32

Increase
Lower

Question 33

What are the 3 principal uses of money?