Lecture Notes Principles of Economics
CH 10 Savings, investment spending and the financial system + Lecture 7 // 30-10
Savings-investment spending identity: savings and investment spending are
always equal for the economy as a whole.
Difference identity and equation: identity is something that’s already true, but they’re
going to prove why.
Total income = total spending: GDP = C + I + G (=closed economy)
Total income = consumption spending + savings: GDP = C + G + S
Total income = consumption spending + investment spending: GDP = C + G + I
Consumption spending + savings = consumption spending + investment spending:
C+G+S=C+G+I
If you subtract C and G from both sides, you get savings = investment spending: S=I
Business spending removed because it assumes that business are not getting
the income because the income is going to the owners and thus individual
private consumers and/or stockholders.
Government savings
Budget spending: the difference between tax revenue and government spending
when tax revenue exceeds government spending
Budget deficit: the difference between tax revenue and government spending when
the government spending exceeds tax revenue
Budget balance: the difference between tax revenue and government spending (T –
G – TR)
National savings: the sum of private savings and the budget balance, is the total
amount of savings generated within the economy (= Sgovernment + Sprivate) >
national savings equals investment (Snational = I) > in a close economy, national
savings is equal to investment (ideological rather than practical)
Open up economy:
You can invest your savings outside and buy imports or build additional savings on
exports. Results in net capital inflow
Net capital inflow (NCI): the total inflow of funds into a country minus the total
outflow of funds of a country (= Imports – Exports)
Trade deficit: buying more than you’re making (imports are higher than exports).
The downside of this is that you have to pay back more than you borrowed and this
money is going abroad > loss of money
A dollar that comes as capital inflow must be repaid with interest to a foreigner
A dollar that comes from national savings is repaid with interest to a foreigner
Investment spending = national savings + net capital inflow
Present value: the present value of X is the amount of money needed today in order
to receive X at a future date given the interest rate.
- High interest rates are bad for markets because it will discourage investment
for two reasons:
- 1. The cost of borrowing is high
- 2. The returns from keeping capital in a bank are high (if you have funds)
,Loanable funds market: a hypothetical market that illustrates the market outcome
of the demand for funds generated by borrowers and the supply of funds provided by
lenders.
- The lower the interest, the greater the quantity of loanable funds demanded
Why it slopes downward?
- When a business engages in investment spending, it spends funds fnow in
return for a future payoff
Equilibrium interest rate: the interest rate at which the quantity of loanable funds
supplied equals the quantity of loanable funds demanded is the equilibrium interest
rate.
- Only projects that are profitable above the equilibrium will still be funded
Crowding out: occurs when a government budget deficit drives up the interest rate
and leads to reduced investment spending > crowd ‘good’ borrowers out of the
market
Shifts of the demand for loanable funds:
1. Changes in perceived business opportunities (change in beliefs about the
payoff of investment spending)
2. Changes in government borrowing (budget deficits) > crowding out
3. Shift to the right: interest rate will go up
Shifts of the supply of loanable funds:
1. Changes in private savings behavior
2. Changes in net capital inflows (investors’ perceptions change)
Real interest rate = nominal interest rate – inflation rate
Why use nominal interest rate and not real interest rate? Because in the real world
neither borrowers nor lenders know what the future inflation rate will be when they
make a deal
, The Fisher Effect: according to the fisher effect, an increase in expected future
inflation drives up the nominal interest rate, leaving the expected real interest rate
unchanged. Basically, both lenders and borrowers base their decisions on the
expected real interest rate > change in expected rate of inflation doesn’t affect the
equilibrium quantity of loanable funds or the expected real interest rate; all it affects
is the equilibrium nominal interest rate (figure 10.7)
Wealth: value of accumulated savings: invest in financial assets
Financial asset: a paper claim that entitles the buyer to future income from the
seller (loans, stocks, bonds, and bank deposits)
- Loan: lending agreement between an individual lender and an individual
borrower > high transaction costs (interest)
- Default: occurs when a borrower fails to make payments as specified by the
loan or bond contract (=risk!)
- Bond: IOU issued by the borrower. Sellers promises to pay a fixed sum of
interest each year and to repay the principal on a particular date. It can be
sold and issues interest each year.
- Loan-backed security: an asset creating by pooling individual loans and
selling shares in that pool. They are traded on markets like bonds. Preferred
by investors because they provide more diversification and liquidity than
individual loans.
- Stocks: a share in the ownership of a company > does not pay annual interest
- Real-estate
Physical asset: tangible object that can be used to generate future income
Human asset: improvement of labor force via education and skills and experience
Liability: a requirement to pay income in the future
Three tasks of a financial system:
1. Reducing Transaction costs: the expenses of negotiating and executing a
deal
CH 10 Savings, investment spending and the financial system + Lecture 7 // 30-10
Savings-investment spending identity: savings and investment spending are
always equal for the economy as a whole.
Difference identity and equation: identity is something that’s already true, but they’re
going to prove why.
Total income = total spending: GDP = C + I + G (=closed economy)
Total income = consumption spending + savings: GDP = C + G + S
Total income = consumption spending + investment spending: GDP = C + G + I
Consumption spending + savings = consumption spending + investment spending:
C+G+S=C+G+I
If you subtract C and G from both sides, you get savings = investment spending: S=I
Business spending removed because it assumes that business are not getting
the income because the income is going to the owners and thus individual
private consumers and/or stockholders.
Government savings
Budget spending: the difference between tax revenue and government spending
when tax revenue exceeds government spending
Budget deficit: the difference between tax revenue and government spending when
the government spending exceeds tax revenue
Budget balance: the difference between tax revenue and government spending (T –
G – TR)
National savings: the sum of private savings and the budget balance, is the total
amount of savings generated within the economy (= Sgovernment + Sprivate) >
national savings equals investment (Snational = I) > in a close economy, national
savings is equal to investment (ideological rather than practical)
Open up economy:
You can invest your savings outside and buy imports or build additional savings on
exports. Results in net capital inflow
Net capital inflow (NCI): the total inflow of funds into a country minus the total
outflow of funds of a country (= Imports – Exports)
Trade deficit: buying more than you’re making (imports are higher than exports).
The downside of this is that you have to pay back more than you borrowed and this
money is going abroad > loss of money
A dollar that comes as capital inflow must be repaid with interest to a foreigner
A dollar that comes from national savings is repaid with interest to a foreigner
Investment spending = national savings + net capital inflow
Present value: the present value of X is the amount of money needed today in order
to receive X at a future date given the interest rate.
- High interest rates are bad for markets because it will discourage investment
for two reasons:
- 1. The cost of borrowing is high
- 2. The returns from keeping capital in a bank are high (if you have funds)
,Loanable funds market: a hypothetical market that illustrates the market outcome
of the demand for funds generated by borrowers and the supply of funds provided by
lenders.
- The lower the interest, the greater the quantity of loanable funds demanded
Why it slopes downward?
- When a business engages in investment spending, it spends funds fnow in
return for a future payoff
Equilibrium interest rate: the interest rate at which the quantity of loanable funds
supplied equals the quantity of loanable funds demanded is the equilibrium interest
rate.
- Only projects that are profitable above the equilibrium will still be funded
Crowding out: occurs when a government budget deficit drives up the interest rate
and leads to reduced investment spending > crowd ‘good’ borrowers out of the
market
Shifts of the demand for loanable funds:
1. Changes in perceived business opportunities (change in beliefs about the
payoff of investment spending)
2. Changes in government borrowing (budget deficits) > crowding out
3. Shift to the right: interest rate will go up
Shifts of the supply of loanable funds:
1. Changes in private savings behavior
2. Changes in net capital inflows (investors’ perceptions change)
Real interest rate = nominal interest rate – inflation rate
Why use nominal interest rate and not real interest rate? Because in the real world
neither borrowers nor lenders know what the future inflation rate will be when they
make a deal
, The Fisher Effect: according to the fisher effect, an increase in expected future
inflation drives up the nominal interest rate, leaving the expected real interest rate
unchanged. Basically, both lenders and borrowers base their decisions on the
expected real interest rate > change in expected rate of inflation doesn’t affect the
equilibrium quantity of loanable funds or the expected real interest rate; all it affects
is the equilibrium nominal interest rate (figure 10.7)
Wealth: value of accumulated savings: invest in financial assets
Financial asset: a paper claim that entitles the buyer to future income from the
seller (loans, stocks, bonds, and bank deposits)
- Loan: lending agreement between an individual lender and an individual
borrower > high transaction costs (interest)
- Default: occurs when a borrower fails to make payments as specified by the
loan or bond contract (=risk!)
- Bond: IOU issued by the borrower. Sellers promises to pay a fixed sum of
interest each year and to repay the principal on a particular date. It can be
sold and issues interest each year.
- Loan-backed security: an asset creating by pooling individual loans and
selling shares in that pool. They are traded on markets like bonds. Preferred
by investors because they provide more diversification and liquidity than
individual loans.
- Stocks: a share in the ownership of a company > does not pay annual interest
- Real-estate
Physical asset: tangible object that can be used to generate future income
Human asset: improvement of labor force via education and skills and experience
Liability: a requirement to pay income in the future
Three tasks of a financial system:
1. Reducing Transaction costs: the expenses of negotiating and executing a
deal
