Chapter 10: Savings, investment spending, and the financial system

Question 1

The savings-investment spending identity (SISI)

Answer 1

FACT: savings and investment spending are always =.

Question 2

SISI in a closed economy

Answer 2

1. No exports (X=0) or imports (M = 0)
2. C = consumer spending
   I = investment spending
   G = Gov’t spending
   S = savings
3. GDP = C+ I + G, total income = total spending
4. GDP (total income) = C + G (consumption spending) + S
5. GDP (total income) = C + G (consumption spending) + I
6. C + G + S = C + G + I; S = I

Question 3

Budget surplus

Answer 3

tax revenue > gov’t spending

Question 4

Budget deficit

Answer 4

tax revenue < gov’t spending

Question 5

Budget balance

Answer 5

1. tax revenue = gov’t spending
2. can also refer to a deficit or surplus
3. S = gov’t savings
   T = Tax revenues
   G = Gov’t spending
   TR = value of gov’t transfers
4. S = T - G - TR

Question 6

National savings

Answer 6

1. S (national) = S (gov’t) + S (private)

2. S (national) = I

Question 7

SISI in an open economy

Answer 7

1. Savings need not be spent on investment spending projects in the same country in which savings are generated- this investment can occur in other countries.
2. Any given country:
   a. can receive inflows (foreign savings that finance investment spending in that country)
   b. can generate outflows (domestic savings that finance investment spending in another country)

Question 8

Net capital inflow

Answer 8

= total inflow – total outflow

Question 9

National savings vs capital inflow

Answer 9

1. $1 generated by national savings is different from $1 in capital inflow
2. Both can finance the same $1 in investment spending
3. But any $1 borrowed from a saver must eventually be repaid with interest.

Question 10

Investment spending

Answer 10

Investment spending = S (national) + KI (capital inflow)

I = S (private) + S (gov’t) + (M - X) = S (national) + KI

Question 11

3 different kinds of capital

Answer 11

1. Physical
2. Human
3. Financial

Question 12

Loanable funds market

Answer 12

Hypothetical market that examines the market outcome of demand for funds generated by borrowers and supply of funds provided by lenders

Question 13

Rate of return

Answer 13

Profit earned on the project expressed as a % of it’s cost

Rate of return = (revenue from project - cost of project)/cost of project x 100

Question 14

Shifts of the demand for loanable funds

Answer 14

1. Changes in perceived business opportunities

2. Changes in gov’t borrowing

Question 15

Crowding out

Answer 15

Occurs when a govt deficit drives up the interest rate and leads to reduced investment spending

Question 16

Shifts of the supply for loanable funds

Answer 16

1. Changes in private savings behavior (ex: 2000-06: rising US home prices made many home owners feel richer, more willing to spend more and save less; shifted supply of loanable funds to the left)
2. Changes in capital inflows (Ex: 2003-06: US received large capital inflows from China and Mid East. Helped fuel a big increase in residential investment spending) ? shift to right

Question 17

Interest rates

Answer 17

1. Anything that shifts either supply or demand of loanable funds changes the interest rate

Question 18

Major factors in changes of interest rates

Answer 18

1. changes in govt policy
2. technological innovations that created new investment opportunities
3. Changing expectations about future inflation (shifts both supply and demand for loanable funds)

Question 19

Inflation and interest rates

Answer 19

1. Real Interest rate = nominal interest rate - inflation rate
2. In real world, neither borrowers nor lenders know what the future inflation rate will be when they make a deal
3. Actual loan contracts specify nominal interest rate not real interest rate

Question 20

Fisher Effect

Answer 20

An increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged

Question 21

Financial system

Answer 21

1. A household’s wealth is the value of it’s accumulated savings
2. A financial asset is a paper claim that entitles the buyer to future income from the seller
3. A physical asset is a claim on a tangible object that gives the owner the right to dispose of the object as he/she wishes