Saving, Investment and Financial System

Tutorial Week 3 : Saving, Investment and Financial System 1. Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5 trillion, and public saving is $0.2 trillion. Assuming this economy is closed, calculate consumption, government purchases, national saving, and investment. National savings = Public S + Private S = $0.2 + $0.5 = $ 0.7 Investment = Savings = $0.7 Private S = ( Y – T – C ) C = Y - T - Private S C = $8 - $1.5 - $0.5 = $6 Public S = ( T - G ) G = T - Public S G = $1.5 - $0.2 = $1.3 2. Economists in Funlandia, a closed economy, have collected the following information about the economy for a particular year: Y = 10,000 C = 6,000 T = 1,500 G = 1,700 The economists also estimate that the investment function is: I = 3,300 – 100 r, where r is the country’s real interest rate, expressed as a percentage. Calculate private saving, public saving, national saving, investment, and the equilibrium real interest rate. Private Saving = Y - T - C = 10,000 - 1,500 - 6,000 = 2, 500 Public Saving = T - G = 1,500 - 1,700 = -200 (budget deficit) National Saving = Y - C - G = 10,000 - 6,000 - 1,700 = 2,300 Investment = National Saving = 2,300 3. Explain the difference between saving and investment as defined by a macro-economist. To a macro-economist, saving occurs when a person’s income exceeds his consumption, while investment occurs when a person or firm purchases new capital, such as a house or business equipment. Which of the following situations represent investment? Saving? Explain. a. Your family takes out a mortgage and buys a new house. It is an investment because it is a purchase of new capital b. You use your $200 paycheck to buy stock in AT&T. It is a saving because the income $200 is not spent on consumption. c. Your roommate earns $100 and deposits it in her account at a bank. It is a saving because the $100 is not spent on consumption. d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business. It is an investment because a car is a capital good 3. Suppose the government borrows $20 billion more next year than this year. a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall? Figure 1 illustrates the effect of the $20billion increase in government borrowing. Initially, the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing by $20billion reduces the supply of loanable funds at each interest rate by $20 billion, so the new supply curve, S 2, is shown by a shift to the left of S1 by exactly $20 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing b) What happens to investment? To private saving? To public saving? To national saving? Compare the size of the changes to the $20 billion of extra government borrowing. Investment and national saving will decrease by less than $20B. Public Saving will decrease by $20B Private Saving will increase by less than $20B. c. How does the elasticity of supply of loanable funds affect the size of these changes? The more elastic is the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less d. How does the elasticity of demand for loanable funds affect the size of these changes? The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more e. Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in parts (a) and (b) Private savings will increase because households will save more in order to pay the higher taxes. Offset with the reduction in public saving, equilibrium will also change. Interest rate increment will also decrease & supply of loanable funds will also increase If the increase of private savings is in the same amount of the government borrowing, there will be no shift of the supply curve. 9. In the summer of 2010, Congress passed a farreaching financial reform to prevent another financial crisis like the one experienced in 2008–2009. Consider the following possibilities: a. Suppose that, by requiring firms to comply with strict regulations, the bill increases the costs of investment. On a well-labeled graph, show the consequences of the bill on the market for loanable funds. Be sure to specify changes in the equilibrium interest rate and level of saving and investment. What are the effects of the bill on long-run economic growth? Investment = demand When cost of investment increases, incentive to invest is reduced thus shifting demand curve to the left. A shift to the left will cause a reduction in interest rate equilibrium and also to loanable funds equilibrium. B. Suppose, on the other hand, that by effectively regulating the financial system,the bill increases savers’ confidence in the financial system. Show the consequences of the policy in this situation on a new graph, again noting changes in the equilibrium interest rate and level of saving and investment. Again evaluate the effects on long-run growth. Savings = supply Increased supply of loanable funds, shifting supply curve to the right. Reduced interest rate equilibrium. Increased equilibrium quantity of loanable funds 10. This chapter explains that investment can be increased both by reducing taxes on private saving and by reducing the government budget deficit. a. Why is it difficult to implement both of these policies at the same time? Investment can be increased by reducing taxes on private saving or by reducing the government budget deficit. But reducing taxes on private saving has the effect of increasing the government budget deficit, unless some other taxes are increased or government spending is reduced. So it is difficult to engage in both policies at the same time. b. What would you need to know about private saving to judge which of these two policies would be a more effective way to raise Investment? To know which of these policies would be a more effective way to raise investment, you would need to know: (1) what the elasticity of private saving is with respect to the after-tax real interest rate, because that would determine how much private saving would increase if you reduced taxes on saving (2) how private saving responds to changes in the government budget deficit, because the decline in the government budget deficit could be matched by an equal decline in private saving, so national saving would not increase at all (3) how elastic investment is with respect to the interest rate, because if investment is quite inelastic, neither policy will have much of an impact on investment.