Week 18 - Savings, Capital formation and Financial markets Flashcards
1
Q
What is saving?
A
Saving is the portion of current income that is not spent on current needs. It represents the money set aside for future use.
2
Q
What is the saving rate?
A
The saving rate is the proportion of income that is saved rather than spent, calculated as:
Saving rate = Saving/Income
3
Q
What are some examples of savings?
A
Examples of savings include:
Personal savings (cash or bank accounts)
Money in investment accounts (stocks, bonds, etc.)
Retirement accounts (401(k), IRAs)
Other financial assets
4
Q
What is wealth?
A
Wealth is the total value of assets minus liabilities. It represents the net value of an economic unit’s holdings.
5
Q
What are assets and liabilities?
A
Assets are anything of value that one owns (e.g., houses, cars, savings).
Liabilities are the debts one owes (e.g., mortgages, loans, credit card debt).
6
Q
What is a balance sheet?
A
A balance sheet is a financial statement that lists an economic unit’s assets and liabilities, showing the net worth at a specific point in time.
7
Q
What is an economic unit?
A
An economic unit refers to an individual or organisation (such as a business, household, or government) that makes economic decisions and holds assets and liabilities.
8
Q
What is a flow value in economics?
A
A flow value is defined per unit of time and represents the dynamic movement of goods, services, or money over time, measured as a rate.
Examples include:
Income
Spending
Saving
Wages
9
Q
What is a stock value in economics?
A
A stock value is defined at a specific point in time and represents a static amount.
Examples include:
Wealth
Debt
Investment / Saving flows (as a stock at a point in time)
10
Q
How do flow and stock values relate to each other?
A
The flow of savings causes the stock of wealth to change.
Every dollar saved adds to an individual’s wealth (a stock).
Flows explain changes over time (e.g., income or savings), while stocks provide a snapshot at a specific point (e.g., wealth or debt).
11
Q
What is the impact of a high rate of saving on future wealth?
A
A high rate of saving today leads to an improved standard of living in the future because it increases accumulated wealth over time.
12
Q
How are flows and stocks complementary in economics?
A
Flows help to explain changes over time in the economy (e.g., changes in income, spending, or saving).
Stocks provide a snapshot of the current state of the economy (e.g., total wealth, total debt).
Both are important for understanding economic trends and making informed policy decisions.
13
Q
What are capital gains in economics?
A
Capital gains occur when the value of your assets increases, resulting in a profit.
Examples include:
Higher stock prices
Higher housing values
Selling an asset for a price higher than its purchase price
14
Q
How are capital gains taxed?
A
Capital gains are taxed at a lower rate than ordinary income to incentivise investment and stimulate economic growth.
15
Q
What are capital losses?
A
Capital losses occur when the value of an asset decreases, resulting in a loss.
Examples include:
Damage to an asset (e.g., a car accident damaging the bumper and front headlight).
Selling an asset for a price lower than its purchase price.
16
Q
How is the change in wealth calculated?
A
The change in wealth is calculated as:
Change in wealth = Saving + Capital Gains - Capital Loss
17
Q
How do capital gains and losses affect wealth?
A
Capital gains increase wealth by adding to the value of assets.
Capital losses reduce wealth by decreasing the value of assets or selling them at a loss.
18
Q
What were the main economic trends affecting American household wealth in the 1990s and 2000s?
A
Dot-com boom and housing market bubble increased household wealth.
Increased access to credit led to higher household debt.
19
Q
How did stock and housing prices impact household wealth?
A
Stock prices and housing prices rose rapidly, contributing to increased wealth.
Capital gains from stocks and homes led to higher household wealth.
Households could borrow against increasing capital gains, leading to higher debt levels.
20
Q
What happened to household wealth when the stock market declined from 2000 to 2002?
A
The stock market declined between 2000 and 2002, reducing stock-based wealth.
However, household savings remained low.
The value of privately-owned homes continued to increase rapidly.
21
Q
How did household wealth, savings, and debt patterns change during this period?
A
Household wealth significantly increased, largely due to the housing and stock markets.
Savings rates declined, meaning households were saving less.
There was a significant increase in household debt, as people borrowed against the rising value of assets.
22
Q
How did the trends in household wealth and debt contribute to the 2008 financial crisis?
A
The rise in household wealth was driven by speculative investments in housing and stocks.
The decline in savings and increased household debt set the stage for financial instability.
When the housing market bubble burst, many households were left with high debt and falling asset values, contributing to the 2008 financial crisis.
23
Q
What is life-cycle saving, and why do people save for it?
A
Life-cycle saving is saving for long-term objectives such as:
Retirement
Home purchase
Children’s college attendance
Healthcare costs
It’s aimed at ensuring financial stability for significant life events and future needs.
24
Q
What is precautionary saving, and what are its main purposes?
A
Precautionary saving is saving for protection against unforeseen setbacks and income fluctuations.
It is typically used for:
Loss of job
Medical emergencies
People save for precautionary reasons to ensure they can handle unexpected events without falling into financial difficulty.
25
What is bequest saving, and who tends to engage in it?
Bequest saving is saving to leave an inheritance for future generations.
It is most common among higher-income groups, who have more resources available to pass on.
This type of saving reflects a desire to provide for children or loved ones after death.
26
How does saving contribute to wealth accumulation?
Saving allows individuals to accumulate wealth, which can be used to purchase assets such as:
A home
A business
These assets can generate income or appreciate in value over time, contributing to long-term financial security and wealth growth.
27
What is consumption smoothing, and how does it affect household saving?
Consumption smoothing refers to saving during periods of high income and consuming during periods of low income to maintain a stable standard of living throughout life.
By saving during times of financial surplus, individuals can smooth out fluctuations in their consumption and avoid major changes in their lifestyle when their income decreases.
28
What does the life-cycle saving theory suggest about saving and consumption over a person's lifetime?
The life-cycle saving theory suggests that individuals save in their younger years, consume more when their incomes are higher in middle age, and then dis-save (consume wealth) during retirement.
This theory reflects the idea of substituting current consumption for future consumption and vice versa, based on income levels at different life stages.
29
What does life-cycle saving look like during a person's early years?
Early years are characterised by borrowing and spending more than income (consumption > income).
Individuals may borrow money to substitute current consumption for future consumption, often for major purchases like education, starting a family, or a home.
30
31
How does saving change in middle years?
In the middle years, people tend to save because their income is higher than their consumption (consumption < income).
This phase involves substituting future consumption for current consumption, with individuals saving for retirement and other future needs.
32
What happens to saving during retirement according to the life-cycle saving theory?
During retirement, individuals often engage in dis-saving, where their consumption exceeds income.
They draw on their accumulated wealth (assets, savings) to support their consumption needs, effectively consuming wealth.
33
What does the life-cycle saving theory suggest about saving and income across the lifespan?
The theory suggests that individuals typically save when they are younger and have lower incomes, then consume more when they reach higher income levels in middle age, and dis-save in retirement when their income is limited but they have accumulated wealth.
34
What are some common forms of savings that provide a return?
Savings often take the form of financial assets that pay a return, such as:
Interest-bearing checking accounts
Bonds
Savings accounts
Mutual funds
Stocks
35
How is the real interest rate (r) defined?
The real interest rate is the nominal interest rate (i) minus the rate of inflation (π).
r = i - π
It reflects the increase in purchasing power from holding a financial asset, adjusting for the eroding effects of inflation.
36
Why is the real interest rate important when saving?
The real interest rate measures the marginal benefit of extra saving, showing how much additional wealth or purchasing power a saver gains by saving rather than spending.
It accounts for inflation, ensuring that savers can track how much their wealth truly grows over time.
37
How does the nominal interest rate differ from the real interest rate?
Nominal interest rate is the stated interest rate on financial assets before adjusting for inflation.
Real interest rate adjusts the nominal
38
What is the difference between "Thrifts" and "Spends"?
Thrifts are families that save a higher proportion of their income, meaning they reduce current consumption to save for the future.
Spends are families that consume more of their income in the present and save less.
39
How does higher saving (by Thrifts) impact income growth?
Thrifts save more, leading to higher unearned income (like investment returns).
As a result, Thrifts experience faster income growth over time.
By saving more, they accumulate wealth that generates income, which increases faster than that of Spends.
40
What does the comparison between Thrifts and Spends illustrate about the trade-off between saving and consumption?
The comparison shows that by saving and consuming less in the present (like Thrifts), individuals can benefit from greater future wealth and higher income.
Thrifts experience faster income growth and end up consuming more later in life than those who consume more today (like Spends).
41
What factors may depress the U.S. household savings rate?
Several factors can reduce the household savings rate, including:
Social Security, Medicare, and other government programs for the elderly.
Mortgages with small or no down payment.
Confidence in a prosperous future.
Increasing value of stocks and growing home values.
Readily available home equity loans.
Demonstration effects (social pressure to consume) and status goods.
Low interest rates.
42
How do government programs like Social Security and Medicare affect savings?
Social Security and Medicare reduce the need for individuals to save for retirement and healthcare, as these programs provide financial support for the elderly.
As a result, individuals may save less because they rely on government programs for future security.
43
How do mortgages and home equity loans influence the savings rate?
Mortgages with small or no down payment make it easier for individuals to purchase homes without saving a significant amount upfront, reducing the need for initial savings.
Readily available home equity loans allow homeowners to borrow against their property’s value, making it easier to access funds without saving.
44
How does confidence in the future affect saving behaviour?
If individuals feel confident in a prosperous future, they may be more likely to spend rather than save, assuming that they will continue to have good economic opportunities and income in the future.
45
How do rising stock and home values impact the savings rate?
Increasing stock values and growing home values can lead individuals to feel wealthier, reducing their incentive to save.
As assets increase in value, people may borrow against them or feel less need to save because their wealth is growing through appreciation.
46
How do demonstration effects and status goods affect saving?
Demonstration effects refer to the influence of others' consumption patterns. People may spend more to keep up with peers, contributing to lower savings.
Status goods, which are luxury items people buy to signal wealth or status, also encourage spending over saving, leading to a reduced savings rate.
47
How do low interest rates impact saving behaviour?
Low interest rates reduce the incentive to save because the return on savings and investments is lower.
People may prefer to spend or invest in higher-risk assets rather than saving in low-return accounts.
48
What does national savings refer to in macroeconomics?
National savings is the total savings in an economy, which includes savings from households, businesses, and the government.
It represents the portion of income that is not consumed or spent on government purchases.
49
What are the components of national savings?
National savings includes savings from:
Households: The portion of income not consumed, saved for future needs.
Businesses: The portion of profits not used for immediate consumption or dividends, invested or saved for expansion.
Government: The difference between government revenue (taxes) and government spending (savings or budget surplus).
50
What is the definition of national income and expenditure in macroeconomics?
The economy’s national income (Y) is the total value of income earned and total expenditures in an economy.
The formula for national income is:
Y = C + I + G + NX
Y = Aggregate income or expenditures
C = Consumption expenditure (household spending)
I = Investment spending (business and government investment)
G = Government purchases of goods and services
NX = Net exports (exports minus imports)
51
What does "aggregate income (Y)" represent in the formula Y = C + I + G + NX?
Aggregate income (Y) refers to the total income or expenditures in the economy.
It includes all the income earned by households, businesses, and the government from production and trade.
52
What do the components C, I, G and NX represent in the national income formula?
C: Consumption expenditure—spending by households on goods and services.
I: Investment spending—spending by businesses on capital goods and by households on new housing.
G: Government purchases—spending by the government on goods and services.
NX: Net exports—exports minus imports, reflecting the balance of trade.
53
How are national savings and investment related?
National savings (household, business, and government savings) is used to finance investment spending in the economy.
If savings exceed investment, it can lead to a surplus, which may be used to pay down debt or increase reserves.
If investment exceeds savings, the economy may need to borrow from abroad (reflected in net exports).
54
How do you calculate national savings (S)?
National savings is the portion of current income that is not spent on current needs.
The formula for national savings is: S = Y - C - G
S = National savings
Y = Aggregate income (GDP)
C = Consumption expenditure (household spending)
G = Government spending
55
What assumptions are made to simplify the calculation of national savings?
NX = 0: This means that there are no net exports (exports minus imports).
Investment spending (I) is excluded, as it’s assumed that investment is already accounted for in the savings calculation.
Consumption (C) and government spending (G) are both considered spending on current needs, meaning they don’t contribute to savings.
56
What does the equation S = Y - C - G represent?
National savings (S) is the difference between total income (GDP) and the amount spent on consumption (C) and government spending (G).
It shows how much of the economy’s income is saved rather than spent on immediate consumption or government purchases.
57
What has been the trend in the national savings rate from 1960 to 2019?
Since 1960, the national savings rate has generally ranged from 13% to 15% in recent years.
The national savings rate has been less volatile compared to household savings, indicating a more stable trend over time.
58
What is private saving, and how is it calculated?
Private saving is the total saving by households and businesses.
It is calculated as the difference between income and consumption, including taxes and government transfers.
For households, private saving can be calculated as:
Private Saving = Y - T - C
Y = Total income (GDP)
T = Taxes minus transfers (government taxes minus any transfer payments received)
C = Consumption spending
59
How do taxes, transfers, and government interest payments impact private saving?
Taxes (T) are paid by households from their total income.
Transfers are government payments to households that do not require any goods in return, which increase household income.
Government interest payments are paid to bondholders, which also affect the income available for private saving.
The equation for taxes is:
T = Taxes - Transfers - Government interest payments
60
How is private saving calculated?
Private saving is the portion of after-tax income that is not consumed.
The formula for private saving is:
Private Saving = Y - T - C
Y = Total income (GDP)
T = Taxes (minus transfers)
C = Consumption spending
61
What is the difference between private saving and household saving?
Private saving includes savings by both households and businesses.
Household saving refers to savings by families and individuals from their after-tax income.
Business saving makes up the majority of private saving in the U.S.
Business saving is calculated as:
Business Saving = Revenues - Operating costs - Dividend to shareholders
62
How does business saving relate to capital investment?
Business savings can be used to purchase new capital equipment or investments that expand the business’s productive capacity.
This reinvestment in capital can promote growth and increase future productivity.
63
How is public saving calculated?
Public saving is the portion of the government’s income that is not spent on current needs.
The formula for public saving is:
Public saving = T - G
T = Net taxes (taxes collected by the government)
G = Government spending on current needs (such as public services)
64
What is the formula for national saving and how is it calculated?
National saving is the sum of private saving and public saving.
The formula for national saving is:
S = Private saving + Public saving
Using the previous formulas for private and public savings:
S = (Y - T - C) + (T - G)
Y = Total income (GDP)
T = Taxes
C = Consumption expenditure
G = Government spending
65
How does public saving contribute to national saving?
Public saving helps increase national savings when the government runs a surplus (where T > G).
If the government runs a deficit (where T < G), public saving decreases, which reduces national saving.
National saving is crucial for funding investment and promoting economic growth.
66
What is a balanced budget?
A balanced budget occurs when government spending (G) equals net tax receipts (T).
This means the government is neither running a surplus nor a deficit.
67
What is a government budget surplus?
A budget surplus occurs when net tax receipts (T) exceed government spending (G).
A budget surplus represents public saving because the government is saving rather than spending all of its revenue.
Formula: Budget surplus = T - G
68
What is a government budget deficit?
A budget deficit occurs when government spending (G) exceeds net tax receipts (T).
A budget deficit represents public dissaving, as the government is borrowing to cover the gap.
Formula: Budget Deficit = G - T
69
How does national savings affect a country’s ability to invest in new capital goods?
National savings is crucial for funding investment in new capital goods, which drive economic growth.
Household savings have been low in recent years, while business savings have remained significant.
In the 1990s, government savings increased, but government dissaving in later years contributed to a decline in national savings.
70
What were the trends in the national savings rate from 1960 to 2002?
From 1960 to 2002, the national savings rate was fairly stable.
During this period, there were no extreme fluctuations in national savings.
71
What factors contributed to low savings from 2002 to 2007?
The period from 2002 to 2007 saw:
Economic growth
Low unemployment
Housing and stock market booms
Low interest rates
All of which encouraged more spending and less saving.
This period saw a decline in national savings.
72
How did government dissaving affect the national savings rate from 2002 to 2007?
From 2002 to 2007, the U.S. experienced government dissaving (rising budget deficits), which further contributed to the decline in national savings.
Contributing factors to government dissaving:
Tax cuts for high-income earners
Increased defence spending following 9/11
73
What happened during the 2007-2009 recession in terms of government savings?
During the 2007-2009 recession, the government engaged in much larger dissaving due to:
Decreased tax revenue
Increased government spending on social welfare programs (stimulus, unemployment benefits, etc.)
This led to a further decline in the national savings rate.
74
Why is investment in new capital goods and housing necessary for increasing labor productivity?
Investment involves the creation of new capital goods (e.g., machinery, buildings) and housing, which are essential for improving labor productivity.
By increasing capital, workers are able to produce more goods and services in less time, boosting economic output.
75
How does national saving relate to investment?
National saving is the primary source of funding for investment in an economy.
Savings from households, businesses, and the government are pooled to finance the creation of new capital goods and infrastructure.
76
How do firms decide whether to invest in new capital?
Firms invest in new capital if they expect the investment to be profitable—that is, if the benefit (value of marginal product of capital) exceeds the cost of the investment.
The Cost-Benefit Principle states that firms undertake investment when the marginal benefit (value generated by the new capital) outweighs the cost (expenses related to acquiring and using the capital).
77
What are the cost and benefit factors involved in investment?
Cost:
The cost of using the machine or other capital goods (e.g., maintenance, depreciation, and operating costs).
Benefit:
The marginal product of the capital, or the additional value or output generated by the new capital.
78
Should Lauren start her lawn care business based on the cost-benefit principle?
Initial Investment:
Cost of lawn mower = $4,000
Assume she can resell the mower for $4,000, so no net capital loss.
Ongoing Revenues and Costs:
Net revenue per summer = $6,000
Taxes (20%) reduce net revenue:
6,000−(6,000×0.2)=4,800
Opportunity Cost (Working Elsewhere):
Lauren could earn $4,400 per summer after tax working elsewhere.
Interest on Loan (Cost of Capital):
Interest on the loan = 6% of $4,000 = $240 per year.
Subtracting this cost from the summer revenue:
4,800−240=4,560
Net Benefit of Starting the Business:
After all expenses, her net revenue from the lawn care business is $4,560.
Comparing to Opportunity Cost:
Lauren’s opportunity cost of working elsewhere is $4,400.
The net benefit of starting the business is $4,560, which is higher than working elsewhere.
79
What are the two important costs when making an investment decision?
Price of Capital Goods (PK): The initial cost to acquire the capital (e.g., machinery, equipment).
Real Interest Rate (r): The opportunity cost of investing in the capital instead of alternative uses of the funds (e.g., saving or investing elsewhere).
80
What does opportunity cost mean in the context of investment?
The opportunity cost of an investment is the return or benefit that could have been earned from the next best alternative use of the funds (e.g., saving money at the real interest rate or investing elsewhere).
81
How is the rate of return on an investment calculated?
The rate of return is the ratio of the value of marginal product (VMP) of the investment to its purchase price (PK):
Rate of return = VMP/ PK
The VMP represents the value generated by the additional unit of capital, and the PK is the cost of purchasing that capital.
82
How can we determine if an investment is profitable?
If the rate of return on an investment is greater than the real interest rate (r), the investment is considered profitable.
VMP/PK > r (profitable)
If the rate of return is less than or equal to the real interest rate, the investment is not profitable.
83
What is the Value of the Marginal Product (VMP) of capital, and what factors influence it?
VMP of Capital is the benefit generated by using one additional unit of capital in production. It represents the additional value produced by an extra unit of capital, such as machinery or equipment.
Factors that influence VMP:
Operating and maintenance expenses: These reduce the net benefit derived from the capital.
Taxes on revenues: Higher taxes reduce the VMP.
Technical innovation: New technologies increase the productivity of capital, thus increasing the VMP.
Higher price of the output: If the price of the goods or services produced by the capital increases, it boosts the VMP.
Relative price of goods or services produced: Changes in the demand for the products or services influence the VMP.
84
How do technical innovation and lower taxes affect the value of marginal product (VMP)?
Technical Innovation increases the efficiency and productivity of capital, raising the VMP because it allows capital to generate more output or more valuable output.
Lower Taxes increase the net revenue from capital, thus increasing the VMP because there’s less of the generated income lost to taxation.
85
How does a higher price of output affect the VMP of capital?
A higher price of output means that each unit of the good or service produced by capital is worth more in the market. As a result, the VMP increases because the benefit generated by the capital rises with the price of the output it produces.
86
What role do banks play as financial intermediaries?
Financial Intermediaries are institutions, like banks, that help channel funds from savers to borrowers.
Banks extend credit to borrowers using funds raised from savers. They act as a middleman between those who have money to save and those who need funds for investment.
87
How do banks help savers?
Evaluate Borrowers: Banks assess the quality of potential borrowers, ensuring that savings are directed to reliable and productive investments.
Provide Information: They offer valuable information to savers about the best ways to use their funds.
Risk Sharing: Banks help distribute the risk of investments, making it easier for savers to invest in potentially risky but productive projects.
88
What is the importance of risk sharing in the banking system?
Risk Sharing allows banks to fund projects that are risky but could yield high returns.
By pooling savings from many individuals, banks can diversify the risks and make financing possible for investments that would otherwise be too risky for an individual saver to undertake alone.
89
How do banks specialise in evaluating the quality of borrowers?
Comparative Advantage: Banks have a comparative advantage in evaluating borrowers because they can do it at a lower cost than individual savers.
Banks use their expertise, experience, and systems to assess creditworthiness more efficiently, allowing them to evaluate investment opportunities at a lower cost and with greater accuracy than individual savers.
90
How do banks manage risk and facilitate large loans?
Risk Pooling: Banks pool the savings of many individuals, which enables them to provide large loans to borrowers.
This spreads out risk among many savers, reducing the impact of any single investment’s failure, making it possible to fund large and more diverse investments.
91
What is the role of banks in evaluating investments and directing savings?
Evaluate Investments: Banks gather and evaluate information about potential investments.
Direct Savings: Banks direct savers’ funds to the most productive and reliable investments based on their evaluations.
Service to Depositors: This evaluation process is a key service banks provide, ensuring that savers’ money is used efficiently.
91
How do banks provide access to credit for small businesses and homeowners?
Access to Credit: Banks make loans available to small businesses and homeowners, often acting as the primary or only source of credit for these groups.
Loans Earn Interest: Banks charge interest on these loans, generating income for the bank while providing necessary capital to individuals and businesses.
91
What is a bond, and what are its key components?
A bond is a legal promise to repay a debt, usually including the principal amount and regular interest payments.
Principal Amount: The original amount of money lent when the bond is issued.
Coupon Rate: The interest rate promised by the issuer when the bond is created.
Coupon Payments: Regular interest payments made to the bondholder over the life of the bond.
92
What is a share of stock, and what benefits does it provide to the holder?
A share of stock represents partial ownership in a company.
Dividends: Periodic payments made to stockholders, determined by the company’s management, based on company profits.
Capital Gains: The increase in the price of the stock, which results in a profit when the stock is sold at a higher price than it was purchased.
93
How are stock prices determined in the market?
Stock Prices are determined by the supply and demand in the stock market.
When more people want to buy a stock (high demand), the price goes up.
When more people want to sell a stock (high supply), the price goes down.
94
How do bond and stock markets ensure savings are used for the most productive purposes?
Information Gathering: These markets gather information about prospective borrowers (companies or governments), ensuring that savers invest in opportunities that have the potential to be productive and profitable.
Companies considering issuing bonds or shares know that their financial health and plans will be carefully evaluated by investors, which encourages them to present the most viable, high-return investments.
Risk Sharing: These markets help savers share the risks of lending. By pooling savings and spreading them across various investment opportunities (stocks or bonds), investors reduce the individual risk of a loss, making it possible to fund projects that might otherwise be too risky for one person to take on alone.
95
What are the two key functions of bond and stock markets?
Gathering Information: Investors assess the potential profitability and risks of various investment options, leading to informed decision-making.
Risk Sharing: By diversifying investments in bonds and stocks, individuals and institutions share the risks, making it more feasible to invest in high-potential but risky ventures.
96
How do bond and stock markets channel funds and allocate savings?
Channel Funds: Bond and stock markets help direct funds from savers to borrowers with productive investment opportunities. The sale of new bonds or stocks can finance capital investment, which is crucial for economic growth.
Provision of Information: Like banks, bond and stock markets provide valuable information on investment projects and their risks, helping investors make informed decisions.
Risk Sharing & Diversification:
Risk Sharing: Investors can share risks by pooling their savings, which reduces the financial risk of individual investments.
Diversification: Diversification allows investors to spread their wealth across various investments, which helps lower overall risk by not relying on a single investment.
97
What are the key functions of bond and stock markets?
Channeling Savings: Directing funds from savers to borrowers to finance productive investments.
Risk Sharing: Allowing savers to share the risks of investment projects through pooled funds.
Diversification: Enabling investors to diversify their wealth across different projects to reduce the overall risk of loss.
98
How do the supply of savings and demand for investment relate to the real interest rate?
Supply of Savings (S): The amount of savings available at each real interest rate. As the real interest rate (r) increases, the quantity of savings supplied increases because savers are incentivized by higher returns.
Demand for Investment (I): The amount of savings that borrowers want to borrow at each real interest rate. The quantity of investment demanded decreases as the real interest rate increases, because borrowing becomes more expensive.
99
What happens to savings and investment as the real interest rate changes?
As the real interest rate increases:
The supply of savings increases (more savings are offered).
The demand for investment decreases (fewer investments are made due to higher borrowing costs).
As the real interest rate decreases:
The supply of savings decreases.
The demand for investment increases.
100
What is the role of the equilibrium interest rate in financial markets?
The equilibrium interest rate is the rate at which the amount of savings supplied equals the amount of investment demanded.
If the interest rate (r) is above equilibrium:
There is a surplus of savings (more savings are available than are needed for investment).
If the interest rate (r) is below equilibrium:
There is a shortage of savings (demand for investment exceeds the available savings).
101
How do financial markets adjust to surpluses and shortages?
Equilibrium Principle: Financial markets work like any other market, adjusting to surpluses or shortages.
Surplus: When there is more savings than investment demand, interest rates tend to fall.
Shortage: When investment demand exceeds savings, interest rates tend to rise.
Changes in factors other than the real interest rate (e.g., changes in government policy, consumer confidence, or business expectations) can shift the savings or investment curves, resulting in a new equilibrium.
102
How does technological improvement affect savings and investment?
New technology increases the marginal productivity of capital, making it more attractive for firms to invest.
Increases demand for investment funds, shifting the investment curve to the right.
As a result, savings increase as investors seek to capitalise on new opportunities.
Higher marginal product of capital leads to higher interest rates, reflecting the increased demand for funds.
More eager investment in new technologies, driving up both savings and investment levels.
Example: The tech boom in the 1990s in the U.S. led to a high rate of investment and a corresponding increase in savings.
103
What are the effects of an increase in the government budget deficit?
Government budget deficit increases, which:
Reduces national saving, as the government borrows from private savings to finance the deficit.
Investors compete for a smaller amount of available savings.
This leads to a movement up the investment curve (higher demand for funds).
Higher interest rates occur due to increased borrowing.
Investments become less attractive at higher interest rates.
The level of savings and investment decreases.
Private investment is crowded out because government borrowing uses up available funds.
104
105
What are the benefits of increasing national saving?
Increased national saving leads to:
Greater investment in new capital goods: More savings provide the funds needed for productive investments.
Higher standard of living: With more capital, businesses can increase productivity, leading to higher wages and living standards in the future.
Long-term economic growth: Higher saving rates provide the necessary funds for future economic development.
106
What are some policy options that could increase national saving?
Reduce the government budget deficit: Cutting the deficit reduces government borrowing from private savings, leading to increased national saving.
Politically difficult: Reducing the deficit often requires unpopular measures such as cuts in government spending or increases in taxes.
Increase incentives for households to save:
Federal consumption tax: Shifting taxes from income to consumption could encourage more saving.
Reduce taxes on dividends and investment income: Lower taxes on savings returns encourage people to save more.
107
What are the effects of a higher national saving rate?
Increased investment: More national savings result in greater availability of funds for investment in capital goods (machinery, infrastructure, etc.).
Higher standard of living: Increased capital formation raises productivity, which leads to higher wages and a better quality of life in the long run.
Improved future growth: More savings lead to sustainable economic expansion, as businesses and governments have more funds to invest in long-term projects.
108
What does Keynesian fiscal policy advocate during economic downturns?
Fiscal stimulus during times of depressed income, high unemployment, low inflation, and low interest rates (like the 1930s) to stimulate demand.
The goal is to moderate the economic downturn by increasing government spending or cutting taxes to boost aggregate demand.
109
What did Keynes say about fiscal policy during economic booms?
Fiscal discipline is required during boom periods to prevent the economy from overheating and to ensure debt sustainability.
Governments should aim to save or reduce debt when the economy is growing to avoid inflation and excessive debt.
110
Why did Keynesian "fine-tuning" fall out of favour?
Timing issues: By the time fiscal stimulus measures were passed, the recession would often have already ended.
This lag in policy implementation made it difficult to achieve the intended effects, leading to the policy’s decline in favour.
111
What is pro-cyclical fiscal policy, and why can it be problematic?
Pro-cyclical fiscal policy: Governments increase spending (or cut taxes) during economic booms and cut spending (or raise taxes) during downturns.
This approach can exacerbate economic fluctuations by fueling the boom and worsening the downturn, leading to instability in the economy.
112
What is the debate between austerity and stimulus in fiscal policy?
Austerity: A focus on reducing government spending and debt, often through tax increases or cuts in public services, especially during downturns.
Stimulus: A focus on increasing government spending and cutting taxes to boost demand during recessions.
The best fiscal policy depends on economic conditions, with Keynes favouring stimulus during recessions and fiscal discipline during booms.
113
What is the problem with Keynesian countercyclical fiscal policy in countries with large deficits?
Big deficits during strong economic periods can leave countries with no fiscal space when the next downturn hits.
When the economy is strong, running large deficits might seem justified, but it makes it harder to use fiscal stimulus in the next recession due to high debt levels.
114
How did the Euro Debt Crisis illustrate the effects of large fiscal deficits and austerity?
During the Euro Debt Crisis in 2009, countries with larger fiscal deficits experienced bigger recessions when they had to implement larger fiscal contractions.
Fiscal austerity measures, like reducing government spending or increasing taxes, worsened the economic downturn instead of aiding recovery.
115
How did austerity measures affect debt/GDP ratios during the Eurozone Debt Crisis?
Austerity measures led to a sharp rise in debt/GDP ratios.
Declining GDP outweighed the progress made on reducing budget deficits, meaning the overall debt burden continued to grow despite efforts to cut government spending and increase taxes.
116
How does government borrowing affect bond interest rates, and who are the purchasers of government bonds?
When a government borrows, it issues debt in the form of bonds.
The yield on a bond is the interest rate paid on the debt.
Purchasers of government bonds include pension funds, insurance companies, and overseas investors.
In recent years, the % yield on government debt has been very low for countries such as the UK.
117
What were the key elements of the UK government's fiscal austerity policies before the Covid-19 Crisis?
Fiscal deficit-reduction policy focused on cutting government spending.
Policies included deep cuts in real government spending (e.g., authorities, defence) and welfare caps on annual payments for each family.
In July 2015, Chancellor George Osborne announced a new fiscal rule with the goal of achieving a budget surplus in normal times (when real GDP growth exceeds 1%).
118
How can reducing debt benefit the economy in the long run?
Reducing debt helps to keep U.K. taxes lower in the future by minimising interest payments and financial strain.
119
How can austerity encourage private sector growth?
Shrinking the state reduces government intervention, allowing the private sector more room to expand.
120
What is the opportunity cost argument for austerity?
Billions spent on debt interest could otherwise be invested in public services, infrastructure, or growth-stimulating initiatives.
121
How can cutting deficits boost investor confidence?
Reducing deficits signals fiscal responsibility, encouraging investors to trust in the country’s economic stability.
122
Why is the economic cycle relevant to austerity policy?
The upturn of the economic cycle is seen as the ideal time for governments to borrow less, strengthening finances before the next downturn.
123
How did the UK's economic performance relate to austerity policies?
Some economists argued that the UK's stronger-than-expected growth during austerity showed better performance than predicted by the IMF and higher growth than the European average.
124
How can austerity be expansionary in certain situations?
If government spending cuts are offset by greater increases in aggregate demand, austerity may lead to economic expansion.
125
Why can austerity be self-defeating?
Austerity can be self-defeating if it causes deflation, reducing demand and further weakening the economy.
126
Why might low government bond yields argue against austerity?
When bond yields are low, borrowing costs are cheap, creating an ideal opportunity for infrastructure investment and other growth-focused spending.
127
How can infrastructure investment counter the effects of austerity?
Infrastructure investment boosts aggregate demand, driving economic growth and offsetting the negative effects of spending cuts.
128
Why is austerity risky in a zero interest rate environment?
In a liquidity trap (zero interest rates), monetary policy becomes less effective, making fiscal stimulus a better tool than austerity.
129
How can austerity hinder debt repayment efforts?
Fiscal austerity may slow economic growth, reducing government revenues and making it harder to repay debt.
130
What was the Keynesian critique of the UK's austerity program?
Keynesian economists argued that the UK's austerity policies (2010-2012) were too severe and unnecessary, delaying the economic recovery that had begun in early 2010.
