Chapter 8

Question 1

Saving, Investment, and the financial system

Answer 1

There are various ways for you to finance capital investments.

• Borrow the money, perhaps from a bank or from a friend or relative.
• Convince someone to provide the money for your business in exchange for a share of your future profits.

Financial system is the group of institutions in the economy that help to match one person’s savings with another person’s investment.

Question 2

Saving, Investment, and the financial system

Answer 2

Saving and investment are key ingredients to long-run economic growth.

When a country saves a large portion of its GDP, more resources are available for investment in capital, and higher capital raises a country’s productivity and living standard.

This chapter examines how the financial system works.

Question 3

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY PT2

Answer 3

Financial institutions can be grouped into two categories:
* Financial markets
* Financial intermediaries

At the broadest level, the financial system moves the economy’s scarce resources from savers (people who spend less than they earn) to borrowers (people who spend more than they earn).

Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date.

Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date.

Question 4

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY: Financial Markets

Answer 4

Financial markets are financial institutions through which savers can directly provide funds to borrowers.

Bond is a certificate of indebtedness that specifies the obligation of the borrower to the holder of the bond.

Characteristics:
* The bond’s term
* The bond’s credit risk

The two most important financial markets in our economy are the bond market and the stock market.

Put simply, a bond is an IOU.

It identifies the time at which the loan will be repaid, called the date of maturity, and the rate of interest that will be paid periodically until the loan matures.

The buyer of a bond gives their money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the principal).

Question 5

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY: Financial Markets (cont’d)

Answer 5

Stock represents ownership in a firm and is, therefore, a claim to its profits.

• EQUITY FINANCE: the sale of a stock to raise money.
• The prices at which shares trade on stock exchanges are determined by the supply and demand for the stock.
• STOCK INDEX: an average of a group of stock prices.
  Dow Jones Industrial Average
  S&P/TSX Composite Index

Because stock prices reflect expected profitability, stock indexes are watched closely as possible indicators of future economic conditions.

Question 6

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY: Financial Intermediaries

Answer 6

FINANCIAL INTERMEDIARIES: financial institutions through which savers can indirectly provide funds to borrowers

BANK: the primary function of a bank is to take deposits from savers and use these deposits to make loans to people who want to borrow

In other words, banks help create a special asset that people can use as a medium of exchange.

MUTUAL FUNDS: an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds
* Allows diversification
* Access to the skills of professional money managers

The primary advantage of mutual funds is that they allow people with small amounts of money to diversify.

The term intermediary reflects the role of these institutions in standing between savers and borrowers.

Question 7

Saving and Investment in the National Income Accounts

Answer 7

ACCOUNTING: refers to how various numbers are defined and added up.

The national income accounts include, in particular, GDP and many related statistics.

The rules of national income accounting include several important identities.

Recall that an identity is an equation that must be true because of the way the variables in the equation are defined. Identities are useful to keep in mind because they clarify how different variables are related to one another.

Question 8

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY: Some Important Identities

Answer 8

GDP (Y) = C + I + G + NX

In closed economy:

NX = 0
Y = C + I + G

National saving (S) is the total income in the economy that remains after paying for consumption and government purchases.

S is simply Y - C - G
Y - C - G = I
or
S = I

Substituting S for Y – C – G = I, we can write the last equation as S – I.

Question 9

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY: T (Tax Collected)

Answer 9

Let T denote the taxes collected by government minus transfer payments.

National saving can then be expressed in either of two ways:

S = Y – C – G or S = (Y – T – C) + (T - G)

Question 10

FINANCIAL INSTITUTIONS IN THE CANADIAN ECONOMY: Private vs. Public Saving

Answer 10

Private saving is the income that households have left after paying for taxes and consumption.

• Y - T - C

Public saving is the tax revenue that the government has left after paying for its spending.

• T - G

Budget Deficit: T < G

Budget Surplus: T > G

Buget Balance: T = G

Question 11

Saving and Investment in the National Income Accounts: The Meaning of Saving and Investment

Answer 11

The terms saving and investment can sometimes be confusing.

Although the accounting identity S = I shows that saving and investment are equal for the economy as a whole, this does not have to be true for every individual household or firm.

Question 12

THE MARKET FOR LOANABLE FUNDS

Answer 12

MARKET FOR LOANABLE FUNDS: the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

To keep things simple, we assume that the economy has only one financial market, called the market for loanable funds.

The term loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

Question 13

THE MARKET FOR LOANABLE FUNDS: Supply and Demand for Loanable Funds

Answer 13

Saving is the source of supply for loanable funds.

Investment is the source of demand for loanable funds.

The interest rate is the price of a loan.

Question 14

Figure 8.1: Market for Loanable Funds

Answer 14

Graph with interest rate as y and loanable funds as x

Here the equilibrium interest rate is 5 percent, and $120 billion of loanable funds are supplied and demanded.

The interest rate in the economy adjusts to balance the supply and demand for loanable funds.
The supply of loanable funds comes from national saving, including both private saving and public saving.

The demand for loanable funds comes from firms and households that want to borrow for purposes of investment.

Question 15

THE MARKET FOR LOANABLE FUNDS - Policy 1: Saving Incentives

Answer 15

A higher saving rate could lead to a higher rate of growth of GDP.

• People respond to incentives:
• Consumption taxes like the GST
• RRSPs
• TFSAs
• RESPs

Canadian Familes save more smaller amounts of income than Japan and Germany but more than US

We save more money so we consume less, we save more so firms borrow more
Supply shift right so we have more to give and demand becoms higher too

Same logic for government surplus

Interest rate lowers but demand raises so it supply shifts right

Question 16

THE MARKET FOR LOANABLE FUNDS - Policy 2: Investment Incentives

Answer 16

An investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment.

Higher interest rates = Households save more

Demand shifts to the right and business borrow more

Question 17

THE MARKET FOR LOANABLE FUNDS - Policy 3: Government Budget Deficits and Surpluses

Answer 17

Government debt is the sum of past budget deficits and surpluses.

Crowding out is a decrease in investment that results from government borrowing.

• When a government spends more than it receives in tax revenue, the shortfall is called the government’s budget deficit.
• When a government spends less than it receives in tax revenue, the excess is called the government’s budget surplus.
• When a government spends exactly what it receives in tax revenue it is said to have a balanced budget.

The increased borrowing from the government shifts the supply curve, while increased borrowing by private investors shifts the demand curve. Why?

The model takes the term loanable funds to mean the flow of resources available to fund private investment; thus, a government budget deficit reduces the supply of loanable funds.

Question 18

THE MARKET FOR LOANABLE FUNDS: Policy 3: Government Budget Deficits and Surpluses (cont’d)

Answer 18

VICIOUS CIRCLE: the cycle that results when deficits reduce the supply of loanable funds, increase interest rates, discourage investment, and result in slower economic growth; slower growth leads to lower tax revenue and higher spending on income-support programs, and the result can be even higher budget deficits

VIRTUOUS CIRCLE: the cycle that results when surpluses increase the supply of loanable funds, reduce interest rates, stimulate investment, and result in faster economic growth; faster growth leads to higher tax revenue and lower spending on income-support programs, and the result can be even higher budget surpluses

Question 19

F

FIGURE 8.3 An Increase in the Demand for Loanable Funds (D1 moving right to D2)

Answer 19

If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase.

As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving.

Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $120 billion to $140 billion.

Question 20

FIGURE 8.4 The Effect of a Government Budget Deficit (S1 moving left to S2)

Answer 20

When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving.

The supply of loanable funds decreases, and the equilibrium interest rate rises.

Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment.

Here, when the supply shifts from S1 to S2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $120 billion to $80 billion.

Question 21

FIGURE 8.5 Federal and Provincial/ Territorial Net Debt in Canada (Blue line trailing over the purple line) (Fed over provincial)

Answer 21

The net debt of the federal government and the combined net debts of the provincial and territorial governments are expressed here as a percentage of GDP.

Data on provincial government debt are available only from 1970.

The federal government debt fell dramatically following World War II but then started to increase quickly in 1975 when the government began to run large and persistent deficits.

Beginning in 1980, provincial and territorial governments also began to run sizable budget deficits and so saw their debts increase relative to GDP.

Between 1997 and 2008, both levels of government—but, in particular, the federal government—managed to reduce the size of their debts relative to GDP.

Beginning in 2009 a serious recession caused both levels of government to suffer sizable budget deficits, and as a result their debt-to-GDP ratios jumped up.

The effects of, and the responses to, the COVID-19 pandemic resulted in large increases in the debt ratio of both levels of government in 2021.