CoreMacro

!Lecture 3:

Some further Macroeconomic Issues

Jos&Luis!Peydr!!!(Cass%Business%School)!

%

GDP

What%is%Gross%Domes.c%Product%(GDP)?%%How%is%GDP%related%to%a%na.ons%total%income%and%spending?%%

What%are%the%components%of%GDP?%%%How%is%GDP%corrected%for%ina.on?%Does%GDP%measure%societys%well@being?%

Micro%vs.%Macro%

Microeconomics:%%%The%study%of%how%individual%households%and%rms%make%decisions,%interact%with%one%another%in%markets.%

Macroeconomics:%%%The%study%of%the%economy%as%a%whole.%

%

23/11/14 20:04The curse of weak global demand - FT.com

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November 18, 2014 5:43 pm

Martin Wolf Author alerts

Feeble economic performance has occurred despite the most aggressive monetary policies

avid Cameron, the UK prime minister, states that red warning lights are once again flashing on the dashboard of the globaleconomy. The lights are not as red as in 2008. Nevertheless, the difficulties caused by the fiscal austerity that his governmentrecommends have become particularly evident in Japan and the eurozone. These stagnant high-income economies are the weakestlinks in the world economy. To understand why, one needs to analyse todays most important economic illness: chronic demanddeficiency syndrome.

Jack Lew, US Treasury secretary, provided a sobering overview in a speech delivered in Seattle, en routeto last weekends summit of the group of 20 leading high-income economies in Australia. As he noted,the world is far from achieving the strong, sustainable, and balanced growth, promised at the 2009summit in Pittsburgh.

Global recovery has been uneven, with sharply different trajectories, he said. In the US, domesticdemand surpassed pre-crisis levels in the first quarter of 2012 and is now about 6 per cent higher thanbefore the crisis. Domestic demand in both Japan and the UK is about 2 per cent higher, he added. Butdemand in the eurozone has yet to recover the ground lost during the crisis, remaining more than 4 percent below its pre-crisis level.

What Mr Lew did not add is that this feeble performance even the 6 per cent rise in real demand in theUS over more than six years is pathetic by historical standards occurred despite the most aggressive monetary policies in history. Theofficial intervention rates of the US Federal Reserve, the European Central Bank and the Bank of England have been not far above zerosince late 2008. The ECB struggled to raise rates above 1 per cent in 2011, but then succumbed to the pull of near zero. The Bank ofJapan has been offering near zero rates for two decades.

Yet this has not been nearly enough. All these central banks have increased their balance sheets sharply. In the US and UK, the balance

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The curse of weak global demand

23/11/14 20:04The curse of weak global demand - FT.com

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sheet expansion has stabilised. In the eurozone, the contraction since 2012 is being reversed, while the Bank of Japans balance sheet isheading towards the economic stratosphere, at 80 per cent of gross domestic product and counting.

How do we explain such weak demand, particularly in the eurozone and Japan? Only if we understand this do we have any hope ofdeciding on the right remedies. One can identify three sets of underlying explanations.

The first set stresses the post-crisis overhang of private debt and the damage to confidence caused by the sudden disintegration of thefinancial system. The by-now canonical response consists of cleaning up balance sheets and forced injection of capital into the bankingsystem, supported by stress tests, to convince the public that the financial system is again creditworthy. To this should be added fiscaland monetary support for demand. In this view, a return to growth should be swift.

The second set of explanations denies this last proposition. It argues that the pre-crisisdemand was unsustainable because it relied on huge accumulations of private and publicdebt the former associated with bubbles in property prices. Japan suffered such a post-bubble reversal in private debt accumulation after 1990; the US, UK and Spain after2008. The implication of this is that economies suffer not just from a post-crisis balance-sheet recession, but from an inability to generate credit-driven demand on the pre-crisisscale. Behind the unsustainability of pre-crisis demand lie global imbalances, shifts inincome distribution and structurally weak investment. A symptom is a chronic financialsurplus (excess of income over spending) in the private sector, as in Japan and theeurozone.

The third set of explanations points to a slowdown in potential growth, due to somecombination of demographic changes, slowing rises in productivity and weak investment.But this last set of explanations feeds directly into the second. If growth of potentialsupply is expected to slow, consumption and investment will be weak. That will generate

feeble growth in demand. If central banks fight this, they get bubbles. If they accept it, weak growth of supply turns into a self-fulfillingprophecy.

The high-income economies suffer from all three sets of ailments, to a greater or lesserextent: the US less, Japan and the eurozone more. Even China, albeit enjoying a muchhigher prospective rate of growth, also suffers from the second and third sets of concerns even if it has not suffered a financial crisis. Its growth of recent years was driven byunsustainably rapid accumulations of debt and unsustainably high rates of investment,given the deceleration in its underlying growth.

The reason that extreme policy has been so ineffective is that the economies suffer fromsuch deep-seated ailments. It is not just about weak supply. But it is also not just aboutweak demand. Nor is it just about the debt overhang or financial shocks. Each economyalso has a different combination of ailments.

As a more demographically dynamic and more innovative economy, with low rates ofprivate saving, the chances of escape into normal policy settings are better for the US thanfor the eurozone or Japan. Similarly, as an economy with catch-up potential, China oughtto have a manageable adjustment. But the eurozone and Japan face far bigger challengesin restoring healthy growth. This is because their private sectors are unable to use thesavings they wish to generate. This leaves them with unconventional policy choices,probably even more unconventional than those they have tried. The consequences ofgoing further could be politically devastating, particularly in the eurozone. What thosepossibilities are and why they are so painful will be the topic of my next column.

[email protected]

-------------------------------------------

Letter in response to this column:

A critical shift in consumer psychology / From Albion M Urdank

Income%and%Expenditure%

Gross!Domes3c!Product!(GDP)%measures%%total%income%of%everyone%in%the%economy.%%%

GDP%also%measures%total%expenditure%on%the%economys%output%of%g&s.%%%

For the economy as a whole, income equals expenditure

because every dollar a buyer spends is a dollar of income for the seller.

The%Circular@Flow%Diagram%

a%simple%depic.on%of%the%macroeconomy% illustrates%GDP%as%spending,%revenue,%%factor%payments,%and%income%

Preliminaries:%Factors!of!produc3on%are%inputs%like%labor,%land,%capital,%and%natural%resources.%%%

Factor!payments%are%payments%to%the%factors%of%produc.on%(e.g.,%wages,%rent).%%


Households: !own the factors of production,

sell/rent them to firms for income !buy and consume goods & services

Households Firms

Firms: !buy/hire factors of production,

use them to produce goods and services

!sell goods & services


Markets for Factors of Production

Households Firms

Income (=GDP) Wages, rent, profit (=GDP)

Factors of production

Labor, land, capital

Spending (=GDP)

G & S bought

G & S sold

Revenue (=GDP) Markets for Goods & Services

What%This%Diagram%Omits%

The%government%collects%taxes,%buys%g&s%

The%nancial%system%matches%savers%supply%of%funds%with%%borrowers%demand%for%loans%

The%foreign%sector% trades%g&s,%nancial%assets,%and%currencies%with%the%countrys%residents%

the%market%value%of%all%nal%goods%&%services%produced%within%a%country%%in%a%given%period%of%.me.%

Gross%Domes.c%Product%(GDP)%Is%

Goods are valued at their market prices, so: !All goods measured in the same units

(e.g., dollars in the U.S.) !Things that dont have a market value are

excluded, e.g., housework you do for yourself.



Final goods: intended for the end user Intermediate goods: used as components or ingredients in the production of other goods

GDP only includes final goodsthey already embody the value of the intermediate goods used in their production.



GDP includes tangible goods (like DVDs, mountain bikes, beer)

and intangible services (dry cleaning, concerts, cell phone service). GDP includes currently produced goods, not goods produced in the past.



GDP measures the value of production that occurs within a countrys borders, whether done by its own citizens or by foreigners located there.



Usually a year or a quarter (3 months)

The%Components%of%GDP% Recall:%%GDP%is%total%spending.%% Four%components:%

Consump.on%(C)% Investment%(I)%Government%Purchases%(G)%Net%Exports%(NX)%

These%components%add%up%to%GDP%(denoted%Y):%

Y = C + I + G + NX

Consump.on%(C)%

is%total%spending%by%households%on%g&s.%%% Note%on%housing%costs:%%!

For%renters,%%consump.on%includes%rent%payments.%%

For%homeowners,%%consump.on%includes%the%imputed%rental%value%of%the%house,%but%not%the%purchase%price%or%mortgage%payments.%%

Investment%(I)%

is%total%spending%on%goods%that%will%be%used%in%the%future%to%produce%more%goods.%%%

includes%spending%on%capital%equipment%(e.g.,%machines,%tools)%structures%(factories,%oce%buildings,%houses)% inventories%(goods%produced%but%not%yet%sold)%

Note: Investment does not mean the purchase of financial assets like stocks and bonds.

Government%Purchases%(G)%

is%all%spending%on%the%g&s%purchased%by%govt%%at%the%federal,%state,%and%local%levels.%

G%excludes%transfer!payments,%such%as%%Social%Security%or%unemployment%insurance%benets.%%%%They%are%not%purchases%of%g&s.%

Net%Exports%(NX)%

NX%=%exports%%imports% Exports%represent%foreign%spending%on%the%economys%g&s.%%%

Imports%are%the%por.ons%of%C,%I,%and%G%%that%are%spent%on%g&s%produced%abroad.%%%

Adding%up%all%the%components%of%GDP%gives:%Y = C + I + G + NX

U.S.%GDP%and%Its%Components,%2012%

1,915

9,767

6,657

35,459

$49,968

per capita

3.8

19.5

13.3

71.0

100.0

% of GDP

598

3,048

2,078

11,068

$15,596

billions

NX

G

I

C

Y

A C T I V E L E A R N I N G 1 GDP%and%its%components%In%each%of%the%following%cases,%determine%how%much%%GDP%and%each%of%its%components%is%aected%(if%at%all).%A. %Debbie%spends%$200%to%buy%her%husband%dinner%%

at%the%nest%restaurant%in%Boston.%B. %Sarah%spends%$1800%on%a%new%laptop%to%use%in%her%

publishing%business.%%The%laptop%was%built%in%China.%%%C. %Jane%spends%$1200%on%a%computer%to%use%in%her%edi.ng%

business.%%She%got%last%years%model%on%sale%for%a%great%price%from%a%local%manufacturer.%%%

D. %General%Motors%builds%$500%million%worth%of%cars,%%but%consumers%only%buy%$470%million%worth%of%them.%

A C T I V E L E A R N I N G 1 Answers%A. %Debbie%spends%$200%to%buy%her%husband%dinner%%

at%the%nest%restaurant%in%Boston.%

%Consump3on%and%GDP%rise%by%$200.%%%

B. %Sarah%spends%$1800%on%a%new%laptop%to%use%in%her%publishing%business.%%The%laptop%was%built%in%China.%%%

%Investment%rises%by%$1800,%net%exports%fall%%by%$1800,%GDP%is%unchanged.%

A C T I V E L E A R N I N G 1 Answers%C. %Jane%spends%$1200%on%a%computer%to%use%in%her%

edi.ng%business.%%She%got%last%years%model%on%sale%for%a%great%price%from%a%local%manufacturer.%%%Current%GDP%and%investment%do%not%change,%because%the%computer%was%built%last%year.%

D. %General%Motors%builds%$500%million%worth%of%cars,%but%consumers%only%buy%$470%million%of%them.%%Consump3on%rises%by%$470%million,%%inventory%investment%rises%by%$30%million,%%and%GDP%rises%by%$500%million.%

Real%versus%Nominal%GDP%

Ina.on%can%distort%economic%variables%like%GDP,%so%we%have%two%versions%of%GDP:%%%

Nominal!GDP%%values%output%using%current%prices%%%not%corrected%for%ina.on%

Real!GDP%%values%output%using%the%prices%of%a%base,year, is%corrected%for%ina.on%%%

EXAMPLE:%

Compute%nominal%GDP%in%each%year:%

2011: %$10%x%400%%+%%%%$2%x%1000%% %=%%%$6,000%

2012: %$11%x%500%%+%$2.50%x%1100% %=%%%$8,250%

2013: %$12%x%600%%+%%%%$3%x%1200% %=%%$10,800%

Pizza Latte year P Q P Q 2011 $10 400 $2.00 1000 2012 $11 500 $2.50 1100 2013 $12 600 $3.00 1200

37.5%

Increase:

30.9%

EXAMPLE:%

Compute%real%GDP%in%each%year,%%using%2011%as%the%base%year:%

Pizza Latte year P Q P Q 2011 $10 400 $2.00 1000 2012 $11 500 $2.50 1100 2013 $12 600 $3.00 1200

20.0%

Increase:

16.7%

$10 $2.00

2011: $10 x 400 + $2 x 1000 = $6,000

2012: $10 x 500 + $2 x 1100 = $7,200

2013: $10 x 600 + $2 x 1200 = $8,400

EXAMPLE:%

In%each%year,% nominal%GDP%is%measured%using%the%(then)%current%

prices.%%% real%GDP%is%measured%using%constant%prices%from%the%

base%year%(2011%in%this%example).%

year Nominal

GDP Real GDP

2011 $6000 $6000 2012 $8250 $7200 2013 $10,800 $8400

EXAMPLE:%

The%change%in%nominal%GDP%reects%both%prices%and%quan..es.%%%

year Nominal

GDP Real GDP

2011 $6000 $6000 2012 $8250 $7200 2013 $10,800 $8400

20.0%

16.7%

37.5%

30.9%

! The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation).

Hence, real GDP is corrected for inflation.

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Nominal%and%Real%GDP%in%the%U.S.,%%19652012%

Real GDP (base year

2005)

Nominal GDP

billi

ons

The%GDP%Deator%

The%GDP%deator%is%a%measure%of%the%overall%level%of%prices.%%%

Deni.on:%

! One way to measure the economys inflation rate is to compute the percentage increase in the GDP deflator from one year to the next.

GDP deflator = 100 x nominal GDP real GDP

EXAMPLE:%

Compute%the%GDP%deator%in%each%year:%

year Nominal

GDP Real GDP

GDP Deflator

2011 $6000 $6000 2012 $8250 $7200 2013 $10,800 $8400

2011: 100 x (6000/6000) = 100.0

100.0

2012: 100 x (8250/7200) = 114.6

114.6

2013: 100 x (10,800/8400) = 128.6

128.6

14.6%

12.2%

A C T I V E L E A R N I N G 2 Compu.ng%GDP%

Use the above data to solve these problems:

A. Compute nominal GDP in 2011.

B. Compute real GDP in 2012.

C. Compute the GDP deflator in 2013.

2011 (base yr) 2012 2013 P Q P Q P Q

Good A $30 900 $31 1000 $36 1050 Good B $100 192 $102 200 $100 205

A C T I V E L E A R N I N G 2 Answers%

A. Compute nominal GDP in 2011.

$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2012.

$30 x 1000 + $100 x 200 = $50,000

2011 (base yr) 2012 2013 P Q P Q P Q

Good A $30 900 $31 1,000 $36 1050 Good B $100 192 $102 200 $100 205


C. Compute the GDP deflator in 2013.

Nom GDP = $36 x 1050 + $100 x 205 = $58,300

Real GDP = $30 x 1050 + $100 x 205 = $52,000

GDP deflator = 100 x (Nom GDP)/(Real GDP) = 100 x ($58,300)/($52,000) = 112.1

2011 (base yr) 2012 2013 P Q P Q P Q

Good A $30 900 $31 1,000 $36 1050 Good B $100 192 $102 200 $100 205

GDP%and%Economic%Well@Being%

Real,GDP,per,capita,is,the,main,indicator,of,the,average,persons,standard,of,living.%

But%GDP%is%not%a%perfect%measure%of%%well@being.%%%

Robert%Kennedy%issued%a%very%eloquent%%yet%harsh%cri.cism%of%GDP:%%%

Gross Domestic Product does not allow for the health of our children, the quality of their education, or the joy of their play.

It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country.

It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans. - Senator Robert Kennedy, 1968

GDP%Does%Not%Value:%

the%quality%of%the%environment% leisure%.me% non@market%ac.vity,%such%as%the%child%care%%a%parent%provides%his%or%her%child%at%home%

an%equitable%distribu.on%of%income%

Then%Why%Do%We%Care%About%GDP?%

Having%a%large%GDP%enables%a%country%to%aord%bener%schools,%a%cleaner%environment,%%health%care,%etc.%%%

Many%indicators%of%the%quality%of%life%are%posi.vely%correlated%with%GDP.%%For%example%

GDP%and%Life%Expectancy%in%12%countries%

38

Life

exp

ecta

ncy

(yea

rs)

Real GDP per capita

U.S. Germany

Japan

Mexico

Russia

Brazil

China

India

Indonesia

Pakistan

Bangladesh

Nigeria

GDP%and%Literacy%in%12%countries%

39

Adu

lt Li

tera

cy

(% o

f pop

ulat

ion)

Real GDP per capita

U.S. Germany Japan

Mexico

Russia

Brazil

China

India

Indonesia

Nigeria

Pakistan

Bangladesh

GDP%and%Internet%Usage%in%12%countries%

40

Inte

rnet

Usa

ge

(% o

f pop

ulat

ion)

Real GDP per capita

U.S.

Germany

Japan

Mexico Russia

Brazil

China India

Indonesia

Nigeria

Bangladesh

Pakistan

S U M M A R Y

Gross%Domes.c%Product%(GDP)%measures%a%countrys%total%income%and%expenditure.%

The%four%spending%components%of%GDP%include:%%Consump.on,%Investment,%Government%Purchases,%and%Net%Exports.%

Nominal%GDP%is%measured%using%current%prices.%%Real%GDP%is%measured%using%the%prices%of%a%constant%base%year%and%is%corrected%for%ina.on.%%%

GDP%is%the%main%indicator%of%a%countrys%economic%well@being,%even%though%it%is%not%perfect.%

2. Saving, investment and the financial system

What%are%the%main%types%of%nancial%ins.tu.ons%in%the%U.S.%economy,%and%what%is%their%func.on?%%%

What%are%the%three%kinds%of%saving?%%Whats%the%dierence%between%saving%and%investment?%%%

How%does%the%nancial%system%coordinate%saving%and%investment?%%%

How%do%govt%policies%aect%saving,%investment,%and%the%interest%rate?%

Financial%Ins.tu.ons%

The%nancial!system:%%the%group%of%ins.tu.ons%that%helps%match%the%saving%of%one%person%with%the%investment%of%another.%%

Financial!markets:%%ins.tu.ons%through%which%savers%can%directly%provide%funds%to%borrowers.%%Examples:%

The%Bond%Market.%%%A%bond%is%a%cer.cate%of%indebtedness.%

The%Stock%Market.%%%A%stock%is%a%claim%to%par.al%ownership%in%a%rm.%%

Financial%Ins.tu.ons%

Financial!intermediaries:%%ins.tu.ons%through%which%savers%can%indirectly%provide%funds%to%borrowers.%%Examples:%Banks%%%Mutual!funds! ins.tu.ons%that%sell%shares%to%the%public%and%use%the%proceeds%to%buy%poroolios%of%stocks%and%bonds%

The%Financial%Crisis%of%20082009% A%nancial%crisis%led%to%a%deep%recession%in%the%U.S.%and%

around%the%world.%%A%few%unemployment%rates:%

3

4

5

6

7

8

9

10

11

10-2

007

01-2

008

04-2

008

07-2

008

10-2

008

01-2

009

04-2

009

07-2

009

10-2

009

01-2

010

04-2

010

07-2

010

10-2

010

01-2

011

04-2

011

07-2

011

10-2

011

01-2

012

%%of%lab

or%fo

rce%

USA France U.K. Canada Sweden

FYI:%%Elements%of%Financial%Crises%

Large%decline%in%some%asset%prices% 20082009:%%Housing%prices%fell%30%.%

Insolvencies%at%nancial%ins.tu.ons% 20082009:%%%Banks%and%other%ins.tu.ons%failed%when%many%homeowners%stopped%paying%their%mortgages.%%

Decline%in%condence%in%nancial%ins.tu.ons%% 20082009:%%Customers%with%uninsured%deposits%began%pulling%their%funds%out%of%nancial%ins.tu.ons.%

FYI:%%Elements%of%Financial%Crises% Credit%crunch%

20082009:%%Borrowers%unable%to%get%loans%because%troubled%lenders%not%condent%in%borrowers%credit@worthiness.%

Economic%downturn%20082009:%%Failing%nancial%ins.tu.ons%and%a%fall%in%investment%caused%GDP%to%fall%and%unemployment%to%rise.%%

Vicious%circle%20082009:%%The%downturn%reduced%prots%and%asset%values,%which%worsened%the%crisis.%%

Dierent%Kinds%of%Saving%

Private!saving!!!= %The%por.on%of%households%income%that%is%not%used%for%consump.on%or%paying%taxes%

= %Y T C

Public!saving!= %Tax%revenue%less%government%spending%

=%T G

Na.onal%Saving%

Na3onal!saving!!!= %private%saving%+%public%saving%

= %%%%(Y T C) + (T G)

= Y C G%

=%the%por.on%of%na.onal%income%that%is%not%used%for%consump.on%or%government%purchases%

!

Saving%and%Investment%

Recall%the%na.onal%income%accoun.ng%iden.ty:%Y = C + I + G + NX

For%the%rest%of%this%chapter,%focus%on%the%closed%economy%case:%

Y = C + I + G

% I = Y C G = (Y T C) + (T G)

Saving = investment in a closed economy

national saving

Budget%Decits%and%Surpluses%

Budget!surplus!=%%an%excess%of%tax%revenue%over%govt%spending%=%%T G = %%public%saving%

Budget!decit!=%%a%shoroall%of%tax%revenue%from%govt%spending%=%%G T = %% (public%saving)%

A C T I V E L E A R N I N G 1 A.%%Calcula.ons%

Suppose%GDP%equals%$10%trillion,%%consump.on%equals%$6.5%trillion,%%the%government%spends%$2%trillion%%and%has%a%budget%decit%of%$300%billion.%%%

Find%public%saving,%taxes,%private%saving,%na.onal%saving,%and%investment.%%

A C T I V E L E A R N I N G 1 Answers,%part%A%

Given:%%%%%%Y%=%10.0,%%%%C%=%6.5,%%%%G%=%2.0,%%%%G T%=%0.3%

Public%saving%%%=%%%T G%%%=%%%0.3%

Taxes:%%T%=%G%%0.3%=%1.7%

Private%saving%=%Y T C!=%10%%1.7%%6.5%=%1.8%

Na.onal%saving%=%Y C G%=%10%%6.5%=%2%=%1.5%

Investment%=%na.onal%saving%=%1.5%

A C T I V E L E A R N I N G 1 B.%%How%a%tax%cut%aects%saving% Use%the%numbers%from%the%preceding%exercise,%%

but%suppose%now%that%the%government%cuts%taxes%by%$200%billion.%%%

In%each%of%the%following%two%scenarios,%%determine%what%happens%to%public%saving,%%private%saving,%na.onal%saving,%and%investment.%%1. !Consumers%save%the%full%proceeds%of%the%%

tax%cut.%%%2. !Consumers%save%1/4%of%the%tax%cut%and%spend%the%

other%3/4.%%

A C T I V E L E A R N I N G 1 Answers,%part%B%

In%both%scenarios,%public%saving%falls%by%%$200%billion,%and%the%budget%decit%rises%%from%$300%billion%to%$500%billion.%%1.% %If%consumers%save%the%full%$200%billion,%%

na.onal%saving%is%unchanged,%%so%investment%is%unchanged.%%

2.% %If%consumers%save%$50%billion%and%spend%$150%billion,%then%na.onal%saving%and%investment%each%fall%by%$150%billion.%

A C T I V E L E A R N I N G 1 C.%%Discussion%ques.ons%

The%two%scenarios%from%this%exercise%were:%1. !Consumers%save%the%full%proceeds%of%the%%

tax%cut.%%%2. !Consumers%save%1/4%of%the%tax%cut%and%spend%the%

other%3/4.%%%

Which%of%these%two%scenarios%do%you%think%is%more%realis.c?%

Why%is%this%ques.on%important?%

The%Meaning%of%Saving%and%Investment%

Private!saving%is%the%income%remaining%aser%households%pay%their%taxes%and%pay%for%consump.on.%%%

Examples%of%what%households%do%with%saving:%Buy%corporate%bonds%or%equi.es%Purchase%a%cer.cate%of%deposit%at%the%bank%Buy%shares%of%a%mutual%fund%Let%accumulate%in%saving%or%checking%accounts%

The%Meaning%of%Saving%and%Investment%

Investment%is%the%purchase%of%new%capital.%% Examples%of%investment:%

General%Motors%spends%$250%million%to%build%%a%new%factory%in%Flint,%Michigan.%%

You%buy%$5000%worth%of%computer%equipment%for%your%business.%%%

Your%parents%spend%$300,000%to%have%a%new%house%built.%%%Remember: In economics, investment is NOT

the purchase of stocks and bonds!

The%Market%for%Loanable%Funds%

A%supplydemand%model%of%the%nancial%system%

Helps%us%understand%how%the%nancial%system%coordinates%%saving%&%investment%

how%govt%policies%and%other%factors%aect%saving,%investment,%the%interest%rate%


Assume:%%only%one%nancial%market%All%savers%deposit%their%saving%in%this%market.%All%borrowers%take%out%loans%from%this%market.%There%is%one%interest%rate,%which%is%both%the%return%to%saving%and%the%cost%of%borrowing.%


The%supply%of%loanable%funds%comes%from%saving:%Households%with%extra%income%can%loan%it%out%and%earn%interest.%%

Public%saving,%if%posi.ve,%adds%to%na.onal%saving%and%the%supply%of%loanable%funds.%%%%If%nega.ve,%it%reduces%na.onal%saving%and%the%supply%of%loanable%funds.%%

The%Slope%of%the%Supply%Curve%Interest

Rate

Loanable Funds ($billions)

Supply

An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.

60

3%

80

6%

The%Market%for%Loanable%Funds%The demand for loanable funds comes from investment: !Firms borrow the funds they need to pay for

new equipment, factories, etc. !Households borrow the funds they need to

purchase new houses.

The%Slope%of%the%Demand%Curve%Interest

Rate


Demand

A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.

50

7%

4%

80

Equilibrium%Interest

Rate


Demand

The interest rate adjusts to equate supply and demand. Supply

The eqm quantity of L.F. equals eqm investment and eqm saving.

5%

60

Policy%1:%%Saving%Incen.ves%

Interest Rate


D1

Tax incentives for saving increase the supply of L.F. S1

5%

60

S2

which reduces the eqm interest rate and increases the eqm quantity of L.F.

4%

70

Policy%2:%%Investment%Incen.ves%

Interest Rate


D1

An investment tax credit increases the demand for L.F. S1

5%

60

which raises the eqm interest rate and increases the eqm quantity of L.F.

6%

70

D2

A C T I V E L E A R N I N G 2 Budget%decits%

Use%the%loanable%funds%model%to%analyze%%the%eects%of%a%government%budget%decit:%Draw%the%diagram%showing%the%ini.al%equilibrium.%Determine%which%curve%shiss%when%the%government%runs%a%budget%decit.%%

Draw%the%new%curve%on%your%diagram.%%What%happens%to%the%equilibrium%values%of%the%interest%rate%and%investment?%


Interest Rate


D1

A budget deficit reduces national saving and the supply of L.F.

S1

5%

60

S2

which increases the eqm interest rate and decreases the eqm quantity of L.F. and investment.

6%

50

Budget%Decits,%Crowding%Out,%%and%Long@Run%Growth%

Our%analysis:%%Increase%in%budget%decit%causes%fall%in%investment.%%%%%%The%govt%borrows%to%nance%its%decit,%%leaving%less%funds%available%for%investment.%%

This%is%called%crowding!out.%%% Recall%from%the%preceding%chapter:%%Investment%is%important%for%long@run%economic%growth.%%%Hence,%budget%decits%reduce%the%economys%growth%rate%and%future%standard%of%living.%%%

The%U.S.%Government%Debt%

The%government%nances%decits%by%borrowing%(selling%government%bonds).%%%

Persistent%decits%lead%to%a%rising%govt%debt.%% The%ra.o%of%govt%debt%to%GDP%is%a%useful%measure%of%the%governments%indebtedness%rela.ve%to%its%ability%to%raise%tax%revenue.%%

Historically,%the%debt@GDP%ra.o%usually%rises%during%war.me%and%falls%during%peace.meun.l%the%early%1980s.%%

0%

20%

40%

60%

80%

100%

120%

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

Financial Crisis

U.S.%Government%Debt%%as%a%Percentage%of%GDP,%17902012%

Revolutionary War Civil

War WW1

WW2

CONCLUSION% Like%many%other%markets,%nancial%markets%are%governed%

by%the%forces%of%supply%and%demand.% One%of%the%Ten%Principles%from%Lecture%1:%%%

%%%%%Markets,are,usually,a,good,way,,,,,,,to,organize,economic,ac@vity.,%Financial%markets%help%allocate%the%economys%scarce%resources%to%their%most%ecient%uses.%

Financial%markets%also%link%the%present%to%the%future:%%They%enable%savers%to%convert%current%income%into%future%purchasing%power,%and%borrowers%to%acquire%capital%to%produce%goods%and%services%in%the%future.%

S U M M A R Y

The%U.K.%and%the%U.S.%nancial%system%is%made%up%of%many%types%of%nancial%ins.tu.ons,%like%the%stock%and%bond%markets,%banks,%and%mutual%funds.%%%

Na.onal%saving%equals%private%saving%plus%%public%saving.%%%

In%a%closed%economy,%na.onal%saving%equals%investment.%%The%nancial%system%makes%this%happen.%

S U M M A R Y

The%supply%of%loanable%funds%comes%from%saving.%%The%demand%for%funds%comes%from%investment.%%The%interest%rate%adjusts%to%balance%supply%and%demand%in%the%loanable%funds%market.%%%%

A%government%budget%decit%is%nega.ve%public%saving,%so%it%reduces%na.onal%saving,%the%supply%of%funds%available%to%nance%investment.%%%

When%a%budget%decit%crowds%out%investment,%%it%reduces%the%growth%of%produc.vity%and%GDP.%

The%Nominal%Exchange%Rate% Nominal!exchange!rate:%%the%rate%at%which%%one%countrys%currency%trades%for%another%

We%express%all%exchange%rates%as%foreign%currency%per%unit%of%domes.c%currency.%%%

Some%exchange%rates%as%of%8%July%2012,%%all%per%US$%% %Canadian%dollar:%% %1.02%% %Euro:%% %0.81%% %Japanese%yen:%% %79.67%% %Mexican%peso:%% %13.39%

Apprecia.on%and%Deprecia.on% Apprecia3on!(or%strengthening):%%%an%increase%in%the%value%of%a%currency%%as%measured%by%the%amount%of%foreign%currency%it%can%buy%

Deprecia3on!(or%weakening):%%%a%decrease%in%the%value%of%a%currency%%as%measured%by%the%amount%of%foreign%currency%it%can%buy%

Examples:%%During%2007,%the%U.S.%dollar%% depreciated%9.5%%against%the%Euro% appreciated%1.5%%against%the%S.%Korean%Won%

The%Real%Exchange%Rate%

Real!exchange!rate:%%the%rate%at%which%the%g&s%of%one%country%trade%for%the%g&s%of%another%

Real%exchange%rate%=%%where%P% %=%%domes.c%price%P* ,= %foreign%price%(in%foreign%currency)%e%% %=%%nominal%exchange%rate,%i.e.,%foreign%currency%

per%unit%of%domes.c%currency%

e x P P*

Example%With%One%Good%

A%Big%Mac%costs%$2.50%in%U.S.,%400%yen%in%Japan% e%=%120%yen%per%$% e%x%P,=%price%in%yen%of%a%U.S.%Big%Mac%

%=%%(120%yen%per%$)%%x%%($2.50%per%Big%Mac)%%=%300%yen%per%U.S.%Big%Mac%

Compute%the%real%exchange%rate:%300 yen per U.S. Big Mac

400 yen per Japanese Big Mac =

e x P P*

= 0.75 Japanese Big Macs per U.S. Big Mac

Interpre.ng%the%Real%Exchange%Rate%and%op.mal%monetary%areas/ECB%

The%real%exchange%rate%=%%0.75%Japanese%Big%Macs%per%U.S.%Big%Mac%

Correct%interpreta.on:%%%To%buy%a%Big%Mac%in%the%U.S.,%%a%Japanese%ci.zen%must%sacrice%%an%amount%that%could%purchase%%0.75%Big%Macs%in%Japan.%%%

Op.mal%monetary%areas%and%the%ECB%

CoreMacro

Documents

global recovery

world economy

real demand

domestic demand

precrisis levels

cent higher thanbefore

us federal reserve

us treasury secretary