Lecture 7: Savings, Investment and Government Debt

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1 Lecture 7: Savings, Investment and Government Debt September 18, 2014 Prof. Wyatt Brooks

2 Problem Set 1 returned Announcements Groups for in-class presentations will be announced today SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 1

3 Financial Markets and Growth Financial Markets matter for growth China: Big movement of money in and out of the country Korea: Huge money flowing into the country during the height of its growth Also, they can be at the heart of crises Mexico: 1994 Russia: 1998 Asian Financial Crisis: 1997 Argentina over and over SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 2

4 Investment and Savings Two sides of financial markets Savers: checking accounts, holding stock, buying bonds, pension funds, etc. Investors: borrow money to expand business or meet their cash flow needs Have to understand both sides of the market, and how they interact SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 3

5 Different Kinds of Saving Private saving = The portion of households income that is not used for consumption or paying taxes = Y T C Public saving = Tax revenue less government spending = T G SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 4

6 National saving National Saving = private saving + public saving = (Y T C) + (T G) = Y C G = the portion of national income that is not used for consumption or government purchases SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 5

7 Saving and Investment Recall the national income accounting identity: Y = C + I + G + NX For now, focus on the closed economy case: Y = C + I + G Solve for I: national saving I = Y C G = (Y T C) + (T G) Saving = investment in a closed economy SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 6

8 Budget Deficits and Surpluses Budget surplus = an excess of tax revenue over govt spending = T G = public saving Budget deficit = a shortfall of tax revenue from govt spending = G T = (public saving) SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 7

9 U.S. Budget Deficits and Surpluses, Fraction of GDP ( ) SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 8

10 The Meaning of Saving and Investment Private saving is the income remaining after households pay their taxes and pay for consumption. Examples of what households do with saving: Buy corporate bonds or equities Purchase a certificate of deposit at the bank Buy shares of a mutual fund Let accumulate in saving or checking account Reduce credit card balances SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 9

11 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! SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 10

12 The Market for Loanable Funds A supply-demand model of the financial system Helps us understand how the financial system coordinates saving & investment how government policies and other factors affect saving, investment, the interest rate SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 11

13 The Market for Loanable Funds Assume: only one financial 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. SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 12

14 The Market for Loanable Funds The supply of loanable funds comes from saving: Households with extra income can loan it out and earn interest. Public saving, if positive, adds to national saving and the supply of loanable funds. If negative, it reduces national saving and the supply of loanable funds. SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 13

15 The Slope of the Supply Curve Interest Rate 6% 3% Supply An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied Loanable Funds ($billions) SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 14

16 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. SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 15

17 The Slope of the Demand Curve Interest Rate 7% 4% A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded. Demand Loanable Funds ($billions) SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 16

18 Equilibrium Interest Rate 5% Supply The interest rate adjusts to equate supply and demand. The equilibrium quantity of loanable funds equalizes investment and saving. Demand 60 Loanable Funds ($billions) SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 17

19 Policy 1: Saving Incentives Interest Rate S 1 S 2 Tax incentives for saving increase the supply of L.F. 5% 4% which reduces the eq m interest rate and increases the eq m quantity of L.F. D Loanable Funds ($billions) SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 18

20 Policy 2: Investment Incentives Interest Rate S 1 An investment tax credit increases the demand for L.F. 6% 5% D 2 which raises the eq m interest rate and increases the eq m quantity of L.F. D Loanable Funds ($billions) SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 19

21 A C T I V E L E A R N I N G 2 Exercise Use the loanable funds model to analyze the effects of a government budget deficit: Draw the diagram showing the initial equilibrium. Determine which curve shifts when the government increases its budget deficit. Draw the new curve on your diagram. What happens to the equilibrium values of the interest rate and investment? 20

22 A C T I V E L E A R N I N G 2 Answers Interest Rate S 2 S 1 A budget deficit reduces national saving and the supply of L.F. 6% 5% which increases the eq m interest rate and decreases the eq m quantity of L.F. and investment. D Loanable Funds ($billions) 21

23 Budget Deficits, Crowding Out, and Long-Run Growth Our analysis: Increase in budget deficit causes fall in investment. The government borrows to finance its deficit, leaving less funds available for investment. This is called crowding out. Investment determines the size of the physical capital stock and is one of the factors affecting national income. SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 22

24 Example: Why is the saving rate in China so high? China has a very high rate of savings It is the second largest economy, so this implies an extremely high quantity of savings Huge implications for international asset markets Very low interest rates A lot of money available for borrowing but why does China save so much? SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 23

25 Savings Around the World 5bncppjof8f9_&ctype=l&met_y=ny_gdp_pcap_p p_cd#!ctype=m&strail=false&bcs=d&nselm=s&m et_s=ny_gds_totl_cd&scale_s=lin&ind_s=false&i fdim=country&pit= &hl=en_us&d l=en_us&ind=false SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 24

26 The International Allocation Puzzle One puzzling feature of international capital flows: Typically, capital flows from poor, fast growing countries to rich, slow growing countries This is a puzzle for macroeconomic models Meaning it does not happen in our usual models, but it does in the data The reason we have trouble rationalizing this: If you are going to be much richer in the future, you should prefer to borrow today to consume and pay it off in the future when you re rich OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 25

27 Example: China China has an extremely high savings rate and very fast growth They use their savings to buy low return US assets and send a lot of Chinese goods to the US Normally we think of people wanting to smooth their consumption over time Would prefer constant consumption today and tomorrow to very low consumption today and very high consumption tomorrow Yet this would predict that the US should be lending to China now OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 26

28 Possible Explanations Many possible explanations have been proposed: Unusual age structure in China from the one child policy (Modigliani and Gao, 2004) In the near future, Chinese population will be very old so they are saving now to support consumption then Bad financial markets in China require entrepreneurs to save (Buera and Shin, 2011) Better insurance markets in the US make foreigners want to save here (Mendoza, Quadrini, Rios-Rul, 2009) OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 27

29 Possible Explanations Many possible explanations have been proposed: Currency manipulation strategy: Normally if trade deficits are large, currency prices adjust to balance trade With high taxes and capital controls, the Chinese government uses dollars that enter the economy to purchase US government assets Keeps the RMB from adjusting in value Great example of a policy that maximizes Chinese GDP but is bad for Chinese welfare OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 28

30 Next Class Next class: read chapter 14 Don t forget to start working on Problem Set #2 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 29

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