Chapter 10: Savings, investment spending, and the financial system Flashcards
The savings-investment spending identity (SISI)
FACT: savings and investment spending are always =.
SISI in a closed economy
- No exports (X=0) or imports (M = 0)
- C = consumer spending
I = investment spending
G = Gov’t spending
S = savings - GDP = C+ I + G, total income = total spending
- GDP (total income) = C + G (consumption spending) + S
- GDP (total income) = C + G (consumption spending) + I
- C + G + S = C + G + I; S = I
Budget surplus
tax revenue > gov’t spending
Budget deficit
tax revenue < gov’t spending
Budget balance
- tax revenue = gov’t spending
- can also refer to a deficit or surplus
- S = gov’t savings
T = Tax revenues
G = Gov’t spending
TR = value of gov’t transfers - S = T - G - TR
National savings
- S (national) = S (gov’t) + S (private)
2. S (national) = I
SISI in an open economy
- 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.
- 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)
Net capital inflow
= total inflow – total outflow
National savings vs capital inflow
- $1 generated by national savings is different from $1 in capital inflow
- Both can finance the same $1 in investment spending
- But any $1 borrowed from a saver must eventually be repaid with interest.
Investment spending
Investment spending = S (national) + KI (capital inflow)
I = S (private) + S (gov’t) + (M - X) = S (national) + KI
3 different kinds of capital
- Physical
- Human
- Financial
Loanable funds market
Hypothetical market that examines the market outcome of demand for funds generated by borrowers and supply of funds provided by lenders
Rate of return
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
Shifts of the demand for loanable funds
- Changes in perceived business opportunities
2. Changes in gov’t borrowing
Crowding out
Occurs when a govt deficit drives up the interest rate and leads to reduced investment spending
Shifts of the supply for loanable funds
- 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)
- 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
Interest rates
- Anything that shifts either supply or demand of loanable funds changes the interest rate
Major factors in changes of interest rates
- changes in govt policy
- technological innovations that created new investment opportunities
- Changing expectations about future inflation (shifts both supply and demand for loanable funds)
Inflation and interest rates
- Real Interest rate = nominal interest rate - inflation rate
- In real world, neither borrowers nor lenders know what the future inflation rate will be when they make a deal
- Actual loan contracts specify nominal interest rate not real interest rate
Fisher Effect
An increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged
Financial system
- A household’s wealth is the value of it’s accumulated savings
- A financial asset is a paper claim that entitles the buyer to future income from the seller
- 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
