Topic 7 - Saving and Investment in a Closed Economy

Question 1

True/False: Financial institutions exist to try to match one person’s savings to another’s investment.

Answer 1

True. This moves the economy’s supply of savings from “savers” to “borrowers”.

Question 2

What are the two groups of Financial Institutions?

Answer 2

1. Financial Markets

2. Financial Intermediaries

Question 3

How are savings calculated?

Answer 3

S = (Y-T-C)+(T-G)
Savings = Private Savings + Government Savings
S = (GDP-Taxes-Consumption) + (Taxes - Government Expenditure)

Question 4

What are the three steps of economic growth?

Answer 4

1. Savings
2. Investment
3. Economic Growth

Question 5

True/False: Investment can be divided into active and passive investment.

Answer 5

True.

Question 6

Define: Loanable Funds.

Answer 6

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

Question 7

What are the two kinds of Financial Markets?

Answer 7

1. Share Market

2. Bond Market

Question 8

What are the two kinds of Financial Intermediaries?

Answer 8

1. Banks

2. Managed Funds

Question 9

What are Financial Markets?

Answer 9

Financial Markets are the institutions through which savers can directly provide funds to borrowers.

Question 10

What are Financial Intermediaries?

Answer 10

Financial Intermediaries are financial institutions through which savers can indirectly provide funds to borrowers (Banks).

Question 11

Define: Liquidity.

Answer 11

Liquidity refers to the ease with which an asset can be converted into goods and services.

Question 12

What are the advantages and disadvantages of money as an asset?

Answer 12

Adv: The most liquid asset.
DisAdv: May incur opportunity costs. (Other assets may grow in value over time, due to inflation money may lose value over time).

Question 13

What are Financial Assets?

Answer 13

An asset is defined as anything of value in exchange. Tangible or real assets that are resources.
Intangible or ‘paper’ assets claims to a portion of the ownership of an underlying real asset.

Question 14

What are the two basic categories of intangible assets?

Answer 14

1. Debt, where the holder is entitled to a fixed dollar amount.
2. Equity, pays the holder an amount based on earnings after debt holders have been satisfied.

Question 15

Define: Bond.

Answer 15

A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond.

Question 16

What are the characteristics of a bond?

Answer 16

Term: The length of time until the bond matures (Few months to 30 years).
Credit Risk: The probability that the borrower will fail to pay some of the interest or principal (Government bonds to Junk bonds).
Tax treatment: The way in which the tax laws treat the interest on the bond.

Question 17

Define: Share

Answer 17

A share represents a claim to partial ownership in a firm and is, therefore, a claim to the profits that that firm makes. The sale of shares is called equity financing.

Question 18

Define: Deflation.

Answer 18

A decline in the general price level in the economy. The value of money increases.
(The inflation rate is negative)

Question 19

What are the problems with deflation?

Answer 19

• Increases debt burdens.
• Reduces asset values and wealth.
• Gains to consumers from falling prices may be negated by falling wages.
• The real interest rate rises above the nominal interest rate, discouraging business borrowing.

Question 20

Define: Disinflation.

Answer 20

Disinflation takes place when a deliberate policy to reduce inflation is pursued and is successful.

Question 21

Define: Hyperinflation.

Answer 21

Hyperinflation refers to extremely rapid increases in the general price level (a period of extremely rapid inflation.

Question 22

What are the effects of hyperinflation?

Answer 22

• Money loses value so rapidly that firms and households try to avoid holding it.
• People trying to get rid of money massively increases supply of money and reduces demand, further reducing the value of the money.
• Often associated with political instability, and usually accompanied by a severe recession and economic and political turmoil.

Question 23

What causes inflation?

Answer 23

According to the “Classical Theory of Inflation” changes in the price level are linked to changes in the quantity of money being circulated in the economy.
(This is known as a “demand-pull theory”).

Question 24

What is “Demand-Pull”?

Answer 24

More money > more spending > more pressure on supply > prices are pulled up in the market.

Question 25

What is “Cost-Push”?

Answer 25

price of labour/raw goods increases > prices increase

Question 26

What is the “Producers Price Index”?

Answer 26

The producer price index measures the cost of a basket of goods and services bought by firms rather than consumers.

Question 27

True/False: The Producers Price Index and Consumers Price Index are closely correlated.

Answer 27

True. When one increases the other increases.

Question 28

What are the two major differences between the CPI inflation rate and the GDP Deflator?

Answer 28

1. The GDP Deflator reflects the prices of all goods and services “Produced Domestically” whereas the CPI reflects the prices of all goods and services “Bought by Consumers”.
2. The CPI compares the price of a “Fixed Basket” of goods and services, whereas the GDP compares the prices of all currently produced goods and services.

Question 29

True/False: Cheques work as a medium of exchange, the same as money.

Answer 29

True. Banks help create a medium of exchange by allowing people to write cheques against their deposits.

Question 30

How is money differentiated?

Answer 30

Money is separated into three categories, M1, M2 and M3, based on the liquidity of the form of money.

Question 31

What is M1 money?

Answer 31

M1 money is the most liquid money: notes, coins, cheque accounts, EFTPOS accounts (the last two are known as transaction account balances).

Question 32

What is M2 money?

Answer 32

M1 + other accounts which can easily be converted into spending money, but not directly to buy goods and services. Eg: Call accounts.

Question 33

What is M3 money?

Answer 33

M2 + deposit accounts. Eg: Term Deposits.

Question 34

What are the other names for M1, M2 and M3 money?

Answer 34

M1 money is sometimes called Narrow money, and M2 and M3 are sometimes known as Broad money.

Question 35

True/False: A government surplus is a good thing for the economy.

Answer 35

False. Both surplus and deficit are neither inherently positive or negative.

Question 36

Define: Loanable Funds.

Answer 36

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

Question 37

True/False: Loanable funds work in much the same way as any other market.

Answer 37

True. Supply comes from people with excess money they wish to save and lend out, and demand comes from people who wish to borrow money.

Question 38

What are the axis’ on the supply demand curve for loanable funds?

Answer 38

Interest Rate vs Loanable Funds

Question 39

What is Capital Gains Tax?

Answer 39

Capital gains tax is the tax on the sale of capital goods like houses, businesses etc. Generally speaking it is almost entirely focused on the sale of houses. This is important because the purchase and sale of houses does not add to the economy.

Question 40

Why is the tax on interest income a bad thing?

Answer 40

Because a tax on the income made from the interest from investments encourages people not to save. Saving money means more money is available to be borrowed, which leads to economic growth.

Question 41

What is the FRA?

Answer 41

The Fiscal Responsibility Act was introduced in 1994. The purpose was to never run a budget deficit. This was a success, and the government of NZ ran a budget surplus all the way through till the 2008 crisis.

Question 42

Why did america fail to introduce a Consumption Tax?

Answer 42

Because a tax on all consumption with no tax on income will disproportionately affect people with lower income.

Question 43

What effect does a budget deficit have on the supply of loanable funds?

Answer 43

A budget deficit will reduce the total amount of loanable funds in the economy.

Question 44

What effect does a budget surplus have on the supply of loanable funds?

Answer 44

A budget surplus will increase the total amount of loanable funds in the economy.

Question 45

What is the government debt?

Answer 45

The accumulation of budget deficits, is called the government debt.

Question 46

Why is it so difficult to compare the economies of underdeveloped countries and developed countries?

Answer 46

Because in underdeveloped countries the black economy forms a major portion of the economy, which is not able to be measured.

Question 47

Why does a budget deficit cause a fall in investment?

Answer 47

There is a fall in investment because the government has to borrow money, but as there is a limited amount of loanable funds available, the typical borrower can not take a loan. This effect is called crowding out.

Question 48

What is the real interest rate?

Answer 48

Nominal Interest rate - rate of inflation.
If you’re getting a high interest rate but the money is inflating at the same rate you are gaining no extra purchasing power.