Dr. Gebremeskel H. Gebremariam Test 2 Study Guide
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Chapter 10: Savings, Investment Spending and the Financial System
Savings and Investment Spending
- Savings-Investment Spending Identity:
- Savings and investment spending are always equal for the economy as a whole.
The Savings-Investment Spending Identity in a Closed Economy
- GDP= C + I + G.
- Total Income= total spending. Total income can go to consumer spending (C) or government purchases of goods and services (G) or be saved (S):
- GDP= C + G + S.
- Total Income= consumption spending + savings. Total Spending consists of either consumption soending (C + G) or investment spending (I):
- GDP= C + G + I.
- Total Income= consumption spending + investment spending. Putting these equations together, we get:
- C + G + S= C + G + I.
- Consumption Spending= consumption spending + savings + investment spending. Subtracting (C + G) from both sides:
- S=I or Savings= Investment Spending. We also discuss several other topics like Who bears the burden of tax?
The Savings-Investment Spending Identity
- Budget Surplus:
- Excess of tax revenue over government spending.
- Budget Deficit:
- Excess of government spending over tax revenue.
- Budget Balance:
- The difference between tax revenue and government spending.
- National Savings:
- The sum of private savings and the budget balance (the total amount of savings generated within the economy). If you want to learn more check out What is a risk and what is a hazard?
The Different Kinds of CapitalWe also discuss several other topics like What are the characteristics of possessive?
- Physical Capital:
- Consists of manufactured resources, such as buildings and machines.
- Human Capital:
- Is the improvement in the labor force generated by education and knowledge. - Financial Capital:
- Is the funds from savings that are available for investment spending.
The Savings-Investment Spending Identity in an Open Economy
- Net Capital Inflow:
- The total flow of funds into a country minus the total flow of funds out of a country (imports - exports).
- A country with a positive net capital inflow has an extra flow of funds from abroad that can be used for investment spending.
The Market for Loanable Funds
- Financial Markets:
- Channel the savings of households to businesses that want to borrow in order to purchase capital equipment.
- 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.
- We assume the price of loans is the nominal interest rate.
Present Value Don't forget about the age old question of What are the stages of meiosis?
- Present Value:
- The amount of money needed today to receive a given amount of money at a future date given the interest rate.
- An investment is worth making only if it generates a future return that is greater than the monetary cost of making the investment today. Don't forget about the age old question of What is the meaning of intentional torts?
The Supply of Loanable Funds
- Why does the supply of loanable funds curve slope upward?
- More people are willing to forgo current consumption and make a loan to a borrower when the interest rate is higher.
Shifts of the Demand for Loanable Funds
- Factors that can cause the demand curve for loanable funds to shift:
- Changes in perceived business opportunities
- Changes in government borrowing
- Crowding Out:
- Occurs when a government budget deficit drives up the interest rate and leads to reduced investment spending
- Crowding out is not a concern in a depressed economy; rather, increased government spending raises income (and private savings). We also discuss several other topics like What is social aggregate?
Shifts of the Supply of Loanable Funds
- Factors that can cause the supply curve for loanable funds to shift include:
- Changes in private savings behavior
- Changes in net capital inflows
Inflation and Interest Rates
- Anything that shifts either the supply of loanable funds curve or the demand for loanable funds curve changes the interest rate
- Major changes in the interest rates have been driven by many factors, including: - Changes in government policy
- Technological innovation that created new investment opportunities.
- But most important, people’s expectation about future inflation
- Real interest rate = nominal interest rate - inflation rate.
- The true cost of borrowing (and payoff to lending) is the real interest rate
- Neither lenders nor borrowers know what inflation will be, so loan contracts specify a nominal interest rate.
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.
The Financial System
- The value of a household’s accumulated savings.
- Financial Asset:
- A paper claim that entitles the buyer to future income from the seller.
- Physical Asset:
- A tangible object that can be used to generate future income.
- A requirement to pay income in the future
Three Tasks of a Financial System
- Task 1: Reducing transaction costs
- Transaction costs: the expenses of negotiating and executing a deal.
- Task 2: Reducing risk
- Financial risk: uncertainty about future outcomes that involve financial losses or gains. - Diversification: investing in several assets with unrelated, or independent, risks; reduces risk.
- Task 3: Providing liquidity
- Liquidity: a measure of how quickly an asset can be converted into cash with relatively little loss of value. (If it can be converted quickly, its liquid; if not, illiquid.)
Types of Financial Assets
- An IOU issued by the borrower, usually with a set interest and maturity date - Loan-Backed Securities:
- Assets created by pooling individual loans and selling shares in that pool (a process called securitization)
- A share in the ownership of a company.
- Financial Intermediary:
- An institution that transforms the funds it gathers from many individuals into financial assets.
- Mutual funds
- Pension funds and life insurance companies
- Mutual Fund:
- Financial intermediary that builds stock portfolio and resells shares of this portfolio to individual investors.
Pension Funds and Life Insurance Companies
- Pension Fund:
- A type of mutual fund that holds assets to provide retirement income to its members - Life Insurance Company:
- Sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies.
- A financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers who don’t want to use the stock or bond markets.
- Bank Deposit:
- A financial asset (a claim on the bank’s cash) owned by the depositor-and a liability of the bank that holds it.
Are Stock Markets Efficient?
- According to the Efficient markets hypothesis, asset prices embody all publicly available information.
Chapter 11: Income and Expenditure
- A lot depends on how much consumers spend when they receive more income. - Marginal propensity to consumer, or MPC
- MPC= ΔConsumer Spending / ΔDisposable Income
- ( Δ= change)
- If ΔAAS= autonomous change in aggregate spending and
- ΔY= change in real GDP
- ΔY= 1 / 1-MPC x ΔAAS
- And the Multiplier= ΔY / ΔAAS = 1 / 1-MPC
- (AAS= Autonomous Aggregate Spending)
Current Disposable Income and Consumer Spending
- Current Disposable Income:
- Income after taxes are paid and the government transfers are received.
- 2013: average household disposable income= $45,826
- Average household consumer spending= $42,495
The Consumption Function
- Consumption Function:
- An equation showing how an individual household’s consumer spending varies with the household’s disposable income.
- c= a + MPC x yd
- c= a household’s consumer spending
- yd= household disposable income
- MPC= marginal propensity to consume
- a= a constant, autonomous consumer spending- what a family would
spend even with zero income.
Aggregate Consumption Function
- Aggregate consumption function:
- The relationship for the economy as a whole b/w aggregate disposable income and aggregate consumer spending
- C= A + MPC x YD
- Same form as consumption function, just aggregate
Shifts of the Aggregate Consumption Function
- What causes shifts?
- Changes in expected future disposable income
- Changes in aggregate wealth
What Drives (Planned) Investment Spending?
- Planned Investment Spending:
- The investment spending that businesses intend to undertake during a given period - 1. The interest rate
- 2. Expected future real GDP
- 3. Current level of production capacity
The Interest Rate and Investment Spending
- Interest rates are often the cost of investment projects
- When interest rates are low, more loans are undertaken and investment rises
Expected Future Real GDP, Production Capacity, and Investment Spending - If your firm has extra capacity and doesn’t expect sales to increase, its investment will be lower.
- According to the Accelerator Principle:
- A higher rate of growth in real GDP leads to higher planned investment spending. - A lower growth rate of real GDP leads to lower planned investment spending.
Inventories and Unplanned Investment Spending
- Inventories: Stocks of goods held to satisfy future sales
- Inventory Investment: The value of the change in total inventories held in the economy during a given period.
- Unplanned Inventory Investment: Unplanned changes in inventories occurring when actual sales are more or less than businesses expected.
- Actual Investment Spending: The sum of planned investment spending and unplanned inventory investment.
- So in any period:
- I = I unplanned + I planned
- The economy is in income-expenditure equilibrium when aggregate output (real GDP) is equal to planned aggregate spending.
- Income-expenditure equilibrium GDP:
- The level of real GDP at which real GDP equals planned aggregate spending. - Detail
The Multiplier Process and Inventory Adjustment
- What happens when there’s a shift of the planned aggregate spending line? - Two possible sources of a shift:
- Change in interest rate
- Change in wealth
Chapter 12: Aggregate Demand and Supply
The Aggregate Demand Curve
- Aggregate Demand Curve:
- The relationship b/w the aggregate price level and the quantity of aggregate output demanded by the households, businesses, the government, and the rest of the world.
The Shape of the Aggregate Demand Curve
- Why does a rise in the aggregate price level reduce C, I and X-IM? (Why does the AD curve slope downward?)
- 1. The Wealth Effect: A higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending
- 2. The Interest Rate Effect: A higher aggregate price level makes households hold more money and leads to a rise in interest rates (and a fall in investment spending and consumer spending)
- If the price level drops, planned spending rises at all output levels (from the wealth and interest-rate effects).
- This leads to a multiplier process that moves the income
Shifts of the Aggregate Demand Curve
- The aggregate demand curve shifts because of changes in:
- Change in wealth
- Government policies (fiscal & monetary)
- Size of existing stock of physical capital
The Short-Run Aggregate Supply Curve
- Why does the SRAS curve slope upward?
- Because nominal wages are sticky in the short run
- Nominal Wage: The dollar amount of the wage paid
- Sticky Wages: Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages.
- How do sticky wages affect SRAS?
- Profit per unit= price per unit - production cost per unit
- Nominal wages are often determined by contracts that were signed some time ago.
Shifts of the Short-Run Aggregate Supply Curve
- What happens when something changes production levels at every price level? - The SRAS curve shifts because of changes in:
- Commodity prices
- Nominal Wages
- The SRAS curve shifts RIGHT because of a(n):
- Decrease in commodity prices
- Decrease in nominal wages
- Increase in productivity
- The SRAS curve shifts LEFT because of a(n):
- Increase in commodity prices
- Increase in nominal wages
- Decline in productivity
Long-Run Aggregate Supply Curve
- The Long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied
- Potential Output is:
- The level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible.
Shifts of Aggregate Demand: Short-Run Effects
- A negative demand shock: Total Spending falls
- A positive demand shock: Total Spending rises
Shifts of the SRAS Curve
- A positive supply shock: Total production increases at every price level
- A negative supply shock: Total production falls at every price level
Negative Supply Shocks and Stagflation
- Especially nasty for society is Stagflation:
- The combination of inflation and falling aggregate output that comes with a negative supply shock.
- Recessionary Gap:
- When aggregate output is below potential output
- Inflationary Gap:
- When aggregate output is above potential output
- Output Gap:
- The % difference between actual aggregate output and potential output. - Output Gap= Actual aggregate output - Potential output / Potential output x 100