Macroeconomics- Ch.10

Present value

(of Y dollars) the amount of money needed today in order to receive X dollars at a future date given the interest rate.

wealth

(of a household) the value of accumulated savings.

What relationship would you expect to find between the level of development of a country's financial system and its level of economic development? Explain in terms of the country's level of savings and level of investment spending.

Economic development and growth are the result of, among other factors, investment spending on physical capital. Since investment spending is equal to savings, the greater the amount saved, the higher investment spending will be, and so the higher growth and economic development will be. So the existence of institutions that facilitate savings will help a country's growth and economic development. As a result, a country with a financial system that provides low transaction costs, opportunities for diversification of risk, and high liquidity to its savers will experience faster growth and economic development than a country that doesn't.

Summary 10.3

Financial market fluctuations can be a source of short-run macroeconomic instability. Asset prices are driven by supply and demand as well as by the desirability of competing assets like bonds. Supply and demand also reflect expectations about future asset prices. One view of expectations is the efficient markets hypothesis, which leads to the view that stock prices follow a random walk. Market participants and some economists question the efficient markets hypothesis. In practice, policy-makers don't assume that they can outsmart the market, but they also don't assume that markets will always behave rationally.

Summary 10.2

Households can invest their current savings or their wealth by purchasing either financial assets or physical assets. A financial asset is a seller's liability. A well-functioning financial system reduces transaction costs, reduces financial risk by enabling diversification, and provides liquid assets, which investors prefer to illiquid assets. The four main types of financial assets are loans, bonds, stocks, and bank deposits. A recent innovation is loan-backed securities, which are more liquid and more diversified than individual loans. Bonds with a higher default risk typically must pay a higher interest rate. The most important types of financial intermediaries are mutual funds, pension funds, life insurance companies, and banks. A bank accepts bank deposits, which obliges it to return depositors' cash on demand, and lends those funds to borrowers for long lengths of time.

Summary Ch.10

Investment in physical capital is necessary for long-run economic growth. So in order for an economy to grow, it must channel savings into investment spending. According to the savings-investment spending identity, savings and investment spending are always equal for the economy as a whole. The budget balance is equal to public savings, which is sometimes called government savings. When the government runs a budget surplus, public savings is positive and the government is a source of savings. On the other hand, when the government runs a budget deficit, then public savings is negative and the government is a source of dissavings. In a closed economy, national savings, the sum of private savings plus public savings, must be equal to investment spending. In an open economy, national savings can split between two kinds of investment: (domestic) investment spending and net foreign investment. Alternatively, domestic investment can be financed via national savings and/or negative NFI, which represents a net inflow of financial capital from abroad (i.e., in an open economy, the total savings available for investment in any given country, from both domestic and foreign sources, equals investment). The hypothetical loanable funds market shows how loans from savers are allocated among borrowers with investment spending projects. By showing how gains from trade between lenders and borrowers are maximized, the loanable funds market shows why a well-functioning financial system leads to greater long-run economic growth. Increasing or persistent government budget deficits can lead to crowding out: higher interest rates and reduced investment spending. Changes in perceived business opportunities and government policies that affect investment shift the demand curve for loanable funds; changes in private savings and government budget balance shift the supply curve. In order to evaluate a project in which the return, Y, is realized in the future, you must transform Y into its present value using the interest rate, i. The present value of $1 received one year from now is $1/(1 + i), the amount of money you must lend out today to have $1 one year from now. The present value of a given project rises as the interest rate falls and falls as the interest rate rises. This tells us that the demand curve for loanable funds is downward-sloping. Because neither borrowers nor lenders can know the future inflation rate, loans specify a nominal interest rate rather than a real interest rate. For a given expected future inflation rate, shifts of the demand and supply curves of loanable funds result in changes in the underlying real interest rate, leading to changes in the nominal interest rate. According to the Fisher effect, an increase in expected future inflation raises the nominal interest rate one-to-one so that the expected real interest rate remains unchanged. Households invest their current savings and their wealth—their accumulated savings—by purchasing assets. Assets come in the form of either a financial asset, a paper claim that entitles the buyer to future income from the seller, or a physical asset, a tangible object that can generate future income. A financial asset is also a liability from the point of view of its initial seller (or issuer). There are four main types of financial assets: loans, bonds, stocks, and bank deposits. Each of them serves a different purpose in addressing the three fundamental tasks of a financial system: reducing transaction costs—the cost of making a deal; reducing financial risk—uncertainty about future outcomes that involves financial gains and losses; and providing liquid assets—assets that can be quickly converted into cash without much loss of value (in contrast to illiquid assets, which are not easily converted). Although many small and moderate-size borrowers use bank loans to fund investment spending, larger companies typically issue bonds. Bonds with a higher risk of default must typically pay a higher interest rate. Business owners reduce their risk by selling stock. Although stocks usually generate a higher return than bonds, investors typically wish to reduce their risk by engaging in diversification, owning a wide range of assets whose returns are based on unrelated, or independent, events. Most people are risk-averse, more sensitive to a loss than to an equal-sized gain. Loan-backed securities, a recent innovation, are assets created by pooling individual loans and selling shares of that pool to investors. Because they are more diversified and more liquid than individual loans, bonds are preferred by investors. It can be difficult, however, to assess a bond's quality. Financial intermediaries—institutions such as mutual funds, pension funds, life insurance companies, and banks—are critical components of the financial system. Mutual funds and pension funds allow small investors to diversify, and life insurance companies reduce risk. A bank allows individuals to hold liquid bank deposits that are then used to finance illiquid loans. Banks can perform this mismatch because on average only a small fraction of depositors withdraw their funds at any one time. A well-functioning banking sector is a key ingredient of long-run economic growth. Asset market fluctuations can be a source of short-run macroeconomic instability. Asset prices are determined by supply and demand as well as by the desirability of competing assets, like bonds: when the interest rate rises, prices of stocks and physical assets such as real estate generally fall, and vice versa. Expectations drive the supply of and demand for assets: expectations of higher future prices push today's asset prices higher, and expectations of lower future prices drive them lower. One view of how expectations are formed is the efficient markets hypothesis, which holds that the prices of assets embody all publicly available information. It implies that fluctuations are inherently unpredictable—they follow a random walk. Many market participants and economists believe that, based on actual evidence, financial markets are not as rational as the efficient markets hypothesis claims. Such evidence includes the fact that stock price fluctuations are too great to be driven by fundamentals alone. Policy-makers assume neither that markets always behave rationally nor that they can outsmart them.

Budget balance

The difference between tax revenue and government spending. A positive budget balance is referred to as a budget surplus; a negative budget balance is referred to as a budget deficit; also known as public savings.

Assess the following statement: "Although many investors may be irrational, it is unlikely that over time they will behave irrationally in exactly the same way—such as always buying stocks the day after the TSX has risen by 1%."

The efficient markets hypothesis states that all available information is immediately taken into account in stock prices. So if investors consistently bought stocks the day after the TSX rose by 1%, a smart investor would sell on that day because demand—and so stock prices—would be high. If a profit can be made that way, eventually many investors would be selling, and it would no longer be true that investors always bought stocks the day after the TSX rose by 1%.

Summary 10.1

The savings-investment spending identity is an accounting fact: savings is equal to investment spending for the economy as a whole. The government is a source of savings when it runs a positive budget balance, a budget surplus. Public savings is the government's budget balance. The government is a source of dissavings when it runs a negative budget balance, a budget deficit. National savings must equal investment spending in a closed economy. However, in an open economy, national savings can be split between investment spending and net foreign investment, which may be positive, zero, or negative. When costs or benefits arrive at different times, you must take the complication created by time into account. This is done by transforming any dollars realized in the future into their present value. The loanable funds market matches savers to borrowers. In equilibrium, only investment spending projects with an expected return greater than or equal to the equilibrium interest rate are funded. A government budget deficit will lower the country's national savings—shifting the supply of loanable funds in the market to the left. This drives up the interest rate and reduces investment in equilibrium. Therefore, a government deficit can cause crowding out. Higher expected future inflation raises the nominal interest rate through the Fisher effect, leaving the real interest rate unchanged in the long run.

Rank the following assets in terms of (i) level of transaction costs, (ii) level of risk, and (iii) level of liquidity. a. A bank deposit with a guaranteed interest rate b. A share of a highly diversified mutual fund, which can be quickly sold c. A share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale

The transaction costs for (a) a bank deposit and (b) a share of a mutual fund are approximately equal because each can typically be accomplished by making a phone call, going online, or visiting a branch office. Transaction costs are highest for (c) a share of a family business, since finding a buyer for the share consumes time and resources. The level of risk is lowest for (a) a bank deposit, since these deposits are insured by the Canada Deposit Insurance Corporation (CDIC) up to $100 000, somewhat higher for (b) a share of a mutual fund, since despite diversification, there is still risk associated with holding mutual funds; and highest for (c) a share of a family business, since this investment is not diversified. The level of liquidity is highest for (a) a bank deposit, since withdrawals can usually be made immediately; somewhat lower for (b) a share of a mutual fund, since it may take a few days between selling your shares and the payment being processed; and lowest for (c) a share of a family business, since it can only be sold with the unanimous agreement of other members and it will take some time to find a buyer.

Explain what is wrong with the following statement: "Savings and investment spending may not be equal in the economy as a whole because when the interest rate rises, households will want to save more money than businesses will want to invest."

We know from the loanable funds market that as the interest rate rises, households want to save more and consume less. But at the same time, an increase in the interest rate lowers the number of investment spending projects with returns at least as high as the interest rate. The statement "households will want to save more money than businesses will want to invest" cannot represent an equilibrium in the loanable funds market because it says that the quantity of loanable funds offered exceeds the quantity of loanable funds demanded. If that were to occur, the interest rate must fall to make the quantity of loanable funds offered equal to the quantity of loanable funds demanded.

Bank deposit

a claim on a bank that obliges the bank to give the depositor his or her cash when demanded.

Physical asset

a claim on a tangible object that can be used to generate future income.

Mutual fund

a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of this portfolio to individual investors.

Bank

a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments or investment spending needs of borrowers.

Life insurance company

a financial intermediary that sells policies guaranteeing a payment to a policyholder's beneficiaries when the policyholder dies.

Loanable funds market

a hypothetical market that brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects).

Loan

a lending agreement between an individual lender and an individual borrower. Loans are usually tailored to the individual borrower's needs and ability to pay but carry relatively high transaction costs.

Financial asset

a paper claim that entitles the buyer to future income from the seller. Loans, stocks, bonds, and bank deposits are types of financial assets.

Efficient markets hypothesis

a principle of asset price determination that holds that asset prices embody all publicly available information. The hypothesis implies that stock prices should be unpredictable, or follow a random walk, since changes should occur only in response to new information about fundamentals.

Liability

a requirement to pay income in the future.

pension fund

a type of mutual fund that holds assets in order to provide retirement income to its members.

Suppose that expected inflation rises from 3% to 6%. a. How will the real interest rate be affected by this change? b. How will the nominal interest rate be affected by this change? c. What will happen to the equilibrium quantity of loanable funds?

a. The real interest rate will not change. According to the Fisher effect, an increase in expected inflation drives up the nominal interest rate, leaving the real interest rate unchanged. b. The nominal interest rate will rise by 3%. Each additional percentage point of expected inflation drives up the nominal interest rate by 1 percentage point. c. As we saw in Figure 10-7, as long as inflation is expected, it does not affect the equilibrium quantity of loanable funds. Both the supply and demand curves for loanable funds are pushed upward, leaving the equilibrium quantity of loanable funds unchanged.

What is the likely effect of each of the following events on the stock price of a company? Explain your answers. a. The company announces that although profits are low this year, it has discovered a new line of business that will generate high profits next year. b. The company announces that although it had high profits this year, those profits will be less than had been previously announced. c. Other companies in the same industry announce that sales are unexpectedly slow this year. d. The company announces that it is on track to meet its previously forecast profit target.

a. Today's stock prices reflect the market's expectation of future stock prices, and according to the efficient markets hypothesis, stock prices always take account of all available information. The fact that this year's profits are low is not new information, so it is already built into the share price. However, when it becomes known that the company's profits will be high next year, the price of a share of its stock will rise today, reflecting this new information. b. The expectations of investors about high profits were already built into the stock price. Since profits will be lower than expected, the market's expectations about the company's future stock price will be revised downward. This new information will lower the stock price. c. When other companies in the same industry announce that sales are unexpectedly slow this year, investors are likely to conclude that sales will also be unexpectedly slow for this company. As a result, investors will revise downward their expectations of future profits and of the future stock price. This new information will result in a lower stock price today. d. This announcement will either have no effect on the company's stock price or will increase it only slightly. It does not add any new information, beyond removing some uncertainty about whether the profit forecast was correct. It should therefore result in either no increase or only a small increase in the stock price.

Use a diagram of the loanable funds market to illustrate the effect of the following events on the equilibrium interest rate and investment spending. a. The government reduces a subsidy to investment. b. Retired people generally save less than working people at any interest rate. The proportion of retired people in the population goes up.

a. When the government reduces its subsidy on investment, this makes undertaking investment becomes less attractive, and the demand for loanable funds decreases. This is illustrated by the shift of the demand curve from D1 to D2 in the accompanying diagram. As the equilibrium moves from E1 to E2, the equilibrium interest rate falls from i1 to i2, and the equilibrium quantity of loanable funds decreases from Q1 to Q2. (diagram) b. Savings fall due to the higher proportion of retired people, and the supply of loanable funds decreases. This is illustrated by the leftward shift of the supply curve from S1 to S2 in the accompanying diagram. The equilibrium moves from E1 to E2, the equilibrium interest rate rises from i1 to i2, and the equilibrium quantity of loanable funds falls from Q1 to Q2. (diagram)

All other things unchanged, an increase in loanable funds demand would most likely be caused by: a. an important economic forecast predicting solid economic growth. b. an important economic forecast predicting a looming recession. c. an increase in the market interest rate. d. an increase in the cost of new capital goods.

a. an important economic forecast predicting solid economic growth.

Private savings is equal to: a. income after taxes minus consumption. b. taxes minus government spending on goods and services. c. the total amount of savings accounts plus stocks plus bonds owned by households. d. income plus investment.

a. income after taxes minus consumption.

National savings is the sum of: a. private savings plus the budget balance. b. private savings and government spending. c. investment spending plus consumption. d. consumption spending minus government spending.

a. private savings plus the budget balance.

According to the savings-investment spending identity: a. savings equals investment spending. b. government spending equals tax receipts. c. total income equals consumption spending plus savings. d. savings equals investment spending plus consumption spending.

a. savings equals investment spending.

The government can increase savings by: a. taxing more than it spends. b. spending more than it taxes. c. increasing inflation. d. increasing the deficit.

a. taxing more than it spends.

Savings-investment spending identity

an accounting fact that states that savings and investment spending are always equal for the economy as a whole.

Financial intermediary

an institution, such as a mutual fund, pension fund, life insurance company, or bank, that transforms the funds it gathers from many individuals into financial assets.

Loan-backed securities

assets created by pooling individual loans and selling shares in that pool.

(Figure: Loanable Funds) The accompanying graph shows the market for loanable funds in equilibrium. Which of the following might produce a new equilibrium interest rate of 8% and a new equilibrium quantity of loanable funds of $150 billion? a. Consumers increase consumption as a fraction of disposable income. b. Businesses become more optimistic about the return on investment spending. c. The federal government has a budget surplus rather than a budget deficit. d. There is an increase in capital inflows from other nations.

b. Businesses become more optimistic about the return on investment spending.

A shift away from taxing asset income and toward taxing consumption would lead to: a. a larger demand for loanable funds, a higher interest rate, and slower economic growth. b. a larger supply of loanable funds, a lower interest rate, and faster economic growth. c. a larger government budget deficit and slower economic growth. d. a smaller supply of loanable funds, a higher interest rate, and faster economic growth.

b. a larger supply of loanable funds, a lower interest rate, and faster economic growth.

The government saves when: a. tax revenue is smaller than government spending. b. tax revenue is larger than government spending. c. tax revenue equals government spending. d. tax revenue is positive.

b. tax revenue is larger than government spending.

If the price of an asset is expected to rise in the future: a. asset owners will be more willing to sell it now. b.it will be more in demand today. c. the price of the asset will fall today. d. the market is irrational

b.it will be more in demand today.

(Figure: The Market for Loanable Funds III) If the government in a closed economy finances deficits by selling bonds and it decides to decrease defense spending by $200 billion, the decrease in government spending will encourage _____ in additional private investment spending. a. $400 billion b. $200 billion c. $100 billion d. $0 billion

c. $100 billion (diagram)

(Figure: Loanable Funds Market) If the interest rate is 8% in the loanable funds market, people will want to save approximately: a. $3 million. b. $2 million. c. $4 million. d. $1 million.

c. $4 million. (diagram)

The present value of a future payment is ________ its future dollar amount. a. exactly the same as b. approximately the same as c. less than d. more than

c. less than

Which of the following is NOT one of the three tasks of a financial system? a. reduction of transaction costs b. risk management c. provision of liquidity d. determining fiscal policy

d. determining fiscal policy

All of the following are financial assets, EXCEPT: a. bonds. b. stocks. c. bank deposits. d. gold coins.

d. gold coins.

Higher rates of interest tend to _______ the quantity of loanable funds demanded, and lower rates of interest tend to _______ it. a. increase; reduce b. reduce; reduce c. increase; increase d. reduce; increase

d. reduce; increase

Liquid

describes an asset that can be quickly converted into cash with relatively little loss of value.

Illiquid

describes an asset that cannot be quickly converted into cash with relatively little loss of value.

Diversification

investment in several different assets with unrelated, or independent, risks, so that the possible losses are independent events.

public savings

the difference between net tax revenue (T - TR) and government spending on goods and services, i.e., T - TR - G. A positive budget balance is a budget surplus, a negative budget balance is a budget deficit, and a zero budget balance is a balanced budget.

Budget deficit

the difference between tax revenue and government spending when government spending exceeds tax revenue; dissaving by the government in the form of a budget deficit is a negative contribution to national savings.

Budget surplus

the difference between tax revenue and government spending when tax revenue exceeds government spending; saving by the government in the form of a budget surplus is a positive contribution to national savings.

Transaction costs

the expenses of negotiating and executing a deal.

Default

the failure of a borrower to make payments as specified by the bond or loan contract.

random walk

the movement over time of an unpredictable variable.

crowding out

the negative effect of budget deficits on private investment, which occurs because government borrowing drives up interest rates.

Fisher effect

the principle by which an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged.

National savings

the sum of private savings and the government's budget balance; the total amount of savings generated within the economy.

Net foreign investment (NFI)

the total outflows of funds out of a country minus the total inflows of funds into that country; the difference between the amount of foreign investment undertaken by the country and the amount of domestic investment undertaken by foreigners.

Financial risk

uncertainty about future outcomes that involve financial losses or gains.