Chapter 10: Savings, Investment Spending, and the Financial System

Question 1

What is the financial system?

Answer 1

A set of markets and institutions that channel the funds of savers into productive investment spending

Question 2

What are financial markets?

Answer 2

Markets in which the government, firms, and individuals trade, not goods, but promises to pay in the future

Question 3

What is the savings-investment spending identity?

Answer 3

An accounting fact that savings and investment spending are always equal for the economy as a whole

Question 4

What are national savings?

Answer 4

The sum of private savings and the government’s budget balance: the total amount of savings generated within an economy

Question 5

What are the national savings formulas (in a closed economy)?

Answer 5

Savings (national) = GDP - C - G, Savings (national) = Savings (private) + Savings (public), Savings (national) = (GDP - T + TR - C) + (T - TR - G)

Question 6

What is the relationship between investment spending and national savings (in a closed economy)?

Answer 6

Investment spending = national savings

Question 7

What is the private savings formula?

Answer 7

S (private) = (GDP - T (taxes) + TR (transfers)) - C

Question 8

What are public savings?

Answer 8

The difference between net tax revenue (T - TR) and government spending on goods and services

Question 9

What is the public savings formula?

Answer 9

S (public) = T - TR - G

Question 10

What is the budget balance?

Answer 10

The difference between tax revenue and government spending. A positive budget balance is a budget surplus (revenue > spending) and a negative budget balance is a budget deficit (revenue < spending). It is equivalent to public savings

Question 11

What is a budget surplus?

Answer 11

A positive budget balance (revenue > spending)

Question 12

What is a budget deficit?

Answer 12

A negative budget balance (revenue < spending)

Question 13

What is the budget balance formula?

Answer 13

(T - TR) - G = S (public) = S (government)

Question 14

What is net foreign investment (NFI)?

Answer 14

The net effect of international outflows and inflows of funds on total savings available for investment in any given country

Question 15

What is capital inflow?

Answer 15

The amount of capital flowing from one country to another

Question 16

Are dollars generated by national savings and foreign capital inflow equivalent?

Answer 16

No. They can both finance the same dollars’ worth of investment spending, but any dollar borrowed from a saver must be repaid with interest. A dollar that comes from national savings is paid to someone domestically - either a private party or government. This will go into Canada’s GDP. Dollars repaid to foreigners come at a higher national cost

Question 17

In an open economy, what are the two ways to finance domestic investment?

Answer 17

Domestic funds (via national savings) and foreign funds (via capital inflows, or negative NFI)

Question 18

What is the S(national) formula in an open economy?

Answer 18

S (national) = I + (X - IM), S (national) = I + NFI

Question 19

What is the loanable funds market?

Answer 19

A hypothetical market that brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects)

Question 20

How is the “price” of the loanable funds market determined?

Answer 20

Interest rate

Question 21

What is present value?

Answer 21

The amount of money needed today in order to receive X at a future date, given the interest rate

Question 22

What is the relationship between the interest rate and demand of loanable funds?

Answer 22

The higher the interest rate, the higher the opportunity cost of investment spending. And, the higher the opportunity cost of investment spending, the lower number of investment spending projects firms want to carry out, and therefore the lower the quantity of loanable funds demanded. There is an inverse (negative) relationship between the interest rate and demand for loanable funds.

Question 23

What is the relationship between the interest rate and supply of loanable funds?

Answer 23

Whether a given saver becomes a lender by making funds available depends on the interest rate received in return. By saving your money today and earning interest on it, you are rewarded with higher consumption in the future when the loan you made is repaid with interest. More people are willing to forgo current consumption and lend funds when the interest rate is higher. There is a positive relationship between the interest rate and supply of loanable funds.

Question 24

What is the equilibrium interest rate?

Answer 24

A situation where the interest rate at which the quantity of loanable funds equals the quantity of loanable funds demanded

Question 25

How does the equilibrium interest rate create efficiencies in the loanable funds market?

Answer 25

The right investments get made: the investment spending projects that are actually financed have higher returns/payoffs (in terms of present value). Also, the right people do the saving and lending: the savers who actually lend funds are willing to lend for a lower interest rate than those who do not

Question 26

What factors cause the domestic demand curve for loanable funds to shift?

Answer 26

Changes in perceived business opportunities (i.e. invention of internet) and changes in government policies that affect investment (i.e. tax credit for investment)

Question 27

What factors cause the supply curve of loanable funds to shift?

Answer 27

Changes in private savings behaviour (i.e. growing recession, cutting back on spending) and changes in the government budget balance (i.e., too many consecutive budget deficits = less loanable funds from gov)

Question 28

What is crowding out?

Answer 28

The negative effect of budget deficits on private investment, which occurs because government borrowing drives up interest rates. An increase in private consumption may also crowd out private investment. An increase in private consumption may also crowd out private investment.

Question 29

What is the global loanable funds market?

Answer 29

A situation in which international capital flows are so large that they equalize interest rates across countries. An example includes British lenders attracted by high Canadian interest rates. Britain will send loanable funds to Canada, pushing the interest rate down. It also reduces the amount of loanable funds in Britain, driving British interest rates up. So, international capital inflows will narrow the gap between Canadian and British interest rates

Question 30

What is the most important factor impacting interest rates over time?

Answer 30

Changing expectations about future inflation, which shift both the supply and demand for loanable funds

Question 31

What is the relationship between the Fisher effect and changing interest rates?

Answer 31

According to the Fisher effect, an increase in expected future inflation drives up the nominal interest rate. But both lenders and borrowers base their decisions on the expected real interest rate. As a result, a change in the expected rate of inflation does not affect the equilibrium quantity of loanable funds or the expected real interest rate, all it impacts is the nominal interest rate

Question 32

What does ceteris paribus mean?

Answer 32

“All other things equal.”