Test #2 (chapter 10) Flashcards
Equation for Sprivate?
Sprivate = GDP - T + TR - C
*disposable income minus consumption spending
Interest rates decreased during the 1980s because…
inflation was lowering and so were future expectations of future inflation
In a closed economy, what is the equation for Investment Spending, I?
I = GDP - C - G
Equation for Snational? (national savings) **in closed economy
Snational = GDP - C - G
What are the two aspects of efficiency that equilibrium in the loanable funds market exhibits?
- The right investments get made (right projects are funded)–> investment spending projects that are actually financed have higher payoffs (in terms of present value) than those that do not get financed
those with return at least as high as i - The right people do the saving and lending –> the savers who actually lend funds are willing to lend for lower interest rates than those who do not
those who lend at most at i
Who often pays for private investment spending?
Firms’ physical capital is often financed by other people’s savings
What is the savings-investment spending identity?
Show this with the GDP formulas of total income and total spending
*in closed economy
Savings and investment spending should always be equal for the economy
Total income : GDP = C + G + S(savings)
Total Spending: GDP = C + G + I(investment)
SO…
S=I
Disposable income equation
= GDP - T + TR
What is the budget balance? What is a budget surplus and a budge deficit? What is a balanced budget?
The difference between tax revenue and government spending
(+) Budget surplus = tax revenue > government spending (govt. has savings)
(-) Budget deficit = government spending > tax revenue (govt. dissaves)
Balanced = 0
What is national savings?
The sum of private savings and the budget balance (public savings)
Equations for Spublic and Snational in a CLOSED economy? And how does I play in
Spublic = T - TR - G
Snational = Spublic + Sprivate
AND
Snational = I
so,,, I = Spublic + Sprivate
What is financial capital?
Funds from savings that are available for investment spending (either inflow-domestic investment or outflow-foreign investment)
Define inflow of funds, outflow of funds, and the NFI
inflow of funds = foreign savings that finance domestic investment (capital inflows)
outflow of funds = domestic savings that finance foreign investment (capital outflows)
NFI = total outflow of funds - total inflow of funds
If NFI < 0, then foreigners invest more in the country than the country invests on foreign countries (net capital inflow) (national savings is high)
If NFI > 0, then the country invests more on foreign countries than foreigners invest in the country (net capital outflow)
Explain what changes about NFI in an open economy, and the new equation for national savings in an open economy
In an open economy, NFI = X-IM (net exports
If NFI < 0, then Net export < 0 (more imports than exports)
Recall: GDP = C + I + G + X-IM
ORRR GDP - C - G = I + (X-IM)
SO, since GDP - C - G = national savings…
Snational = I + NFI
OR
Snational - NFI = I
What do financial markets do?
What is the fictional way to look at a financial market? - What would the price of loans be? (vertical axis)
Financial markets channel the savings of households to businesses that want to borrow in order to invest
Fictional financial market = loanable funds market
Price of loans = (nominal) interest rate
Explain the demand curve in the market for loanable funds
When will firms choose to invest?
Demand curve = demand for loans by the firms at a given interest rate
(the interest rate is the opp. cost of investment)
(at lower interest rates, more projects become profitable)
*Firms invest if the PV (present value) of the future return on an investment > cost of investment
What is the PV formula?
PV = FV / (1 + r) ^t
r = interest rate
t = # of periods
Explain the supply curve in the market for loanable funds
Supply curve = supply of funds that are supplied by savers
Slopes upward because more ppl are willing to lend money when the interest rate is higher
At the loanable funds market equilibrium , ____________ = ___________
desired savings = desired investment
At the loanable funds market equilibrium, explain what sides of the graph are funded/not funded
LEFT SIDE:
demand curve - projects ARE funded
supply curve - offers from lenders ARE accepted
RIGHT SIDE:
demand curve - projects ARE NOT funded
supply curve - offers from lenders ARE NOT accepted
What are the factors that can cause the demand curve for loanable funds to shift?
Changes in perceived business opportunities
- ex. huge excitement for business opportunities created by the internet - ppl rushing to buy internet equipment stuff - shifted domestic demand for loanable funds to the right
Changes in government policies that affect investment
- ex. tax credit for investment = a subsidy in the form of lower taxes for those undertaking the targeted type of investment - making investments less expensive to undertake - shift domestic demand for loanable funds to the right
What are the factors that can cause the supply curve for loanable funds to shift?
Changes in private savings behaviour:
- households may worry about the future and want to save more now
ex. COVID caused fear of a recession which meant households cut back on spending - shift domestic supply for loanable funds to the right
Changes in government budget balance:
- budget surplus = more savings = more supply of loanable funds - shift to the right
- budget deficit = dissaves (borrower) = less supply of loanable funds - shift to the left
When does Crowding Out occur?
In what case would it maybe not occur?
Occurs when a govt. budged deficit drives up the interest rate and leads to reduced investment spending (supply curve shifting to the left)
(OR, govt. borrowing goes up –> causes the demand curve to shift to the right)
**if the economy is depressed, crowding out may not occur because govt. spending can increase incomes and increase savings
In the global loanable funds market, what is the incentive for capital flow?
What can the global loanable funds market do?
When can this happen?
There is an incentive for capital to flow to where the returns are higher
*this means that most of the time, capital flows from countries where interest rates are relatively low to countries where interest rates are relatively high
Result is …
A global loanable funds market can equalize interest rates across countries
*this can happen when residents of the two countries believe that foreign assets and foreign liabilities are as good as domestic ones
What are factors that drive the changing of interest rates?
What’s the most important one?
- changes in government policy
- technological innovations that create new investment opportunities
MOST important: - expectations about future inflation (shift both the supply and demand for loanable funds
What is the real interest rate? What is the true cost of borrowing?
The real interest rate = nominal interest rate - inflation rate
The true cost of borrowing (and payoff to lending) is the real interest rate
*but in the real world, neither lenders nor borrowers know what inflation will be, so loan contracts specify a nominal interest rate
What is the Fisher effect?
The expected real interest rate is unaffected by changes in the expected future inflation
Expected future inflation drives up the nominal interest rate
(lenders and borrowers are willing to lend and borrow at a higher nominal interest rate because they know that you would subtract the inflation rate and ultimately be at the same, unchanged real interest rate)
What is behavioural economics? In what ways to investors depart from rationality?
Behavioural economics = the study of how people make predictable mistakes
3 ways:
- overconfidence
- loss aversion
- herd mentality
In what 2 ways can an open economy allocate savings?
- accumulating physical capital by investing domestically
- acquiring foreign assets by investing abroad
