Econ 313 Chapter 4: Saving and Investment in Closed and Open Economies

distinguishing b/w movements along a curve and shift in the curve

- only shifts in curves produce a change in the eq quantities and price -changes in desired saving (S) when the real interest rate (r) changes is a movement along the saving curve and does not cause the saving curve to shift. -changes in Cbar, Tbar, and Gbar can affect the amount of desired saving and thus shift the saving curve

governments stimulate saving through four main methods

- tax consumption : high tax on consumption encourages consumers to spend less and save more, thereby amassing wealth. similar to sales tax is a value-added tax, which is a tax that is paid by a producer on the different bw what it receives for tis goods and services minus costs. - provide tax incentives for saving : IRA - increase return on saving : measure that increase the return on assets like common stock increase the incentives for households to save. - reduce budget deficit : reducing budget deficits increases national saving - but in recent years the opposite has occurred.

changes in autonomous investment

-Changes in desired investment as the real interest rate changes are movements along the investment curve that do not change the equilibrium level of real interest rates. However, changes in desired investment that are unrelated to the real interest rates, that is, autonomous investment, Ibar, do cause the investment curve to shift, which leads to a change in equilibrium real interest rates. -Alternatively, changes in the tax code, such as an investment tax credit, encourage businesses to expand investment at any given real interest rate and also shift the investment curve to the right. -An increase in business optimism or a change in the tax code that increases autonomous investment causes saving, investment, and the real interest rate to rise. -Similar reasoning indicates that when businesses become more pessimistic or the government raises taxes on investment, lowering autonomous investment, the investment curve will shift to the left, and so saving, investment, and the real interest rate will fall. Figure 4.7

US is world's largest debtor

-US was the largest creditor in the world up 1980s -in 1970s, net foreign assets relative to US GDP began to fall; by 2012, net foreign debt (US debt to foreigners minus foreign debt to Americans) was $3.9 trillion -in 1986, net foreign assets turned negative and continued to decline. trade deficit has finally begun to shrunk but bc still negative, net foreign assets continue to fall. -US will be a net debtor to the rest of the world for a long time.

changes in domestic saving

-an increase in saving in the small open economy (from a decrease in autonomous consumption expenditure, a rise in government saving from a rise in taxes, or a decline in government spending) leads to a higher trade balance (an increase in the trade surplus or a shrinkage of the trade deficit) and an increase in net capital outflows. -a decrease in saving leads to a decline in the trade balance (a shrinkage in the trade surplus or an increase in the trade deficit) and a decrease in net capital outflows

crowding out and debate over 2009 fiscal stimulus package

-in 2009, increased spending pushed up budget deficits to over $1 trillion -although the 2009 fiscal stimulus package had potential benefits in terms of increasing employment and output, our saving-investment analysis indicates that we shouldd take these criticisms seriously -even if the Obama fiscal stimulus package were successful in stimulating the US economy in the short run, it could have important negative long-run consequences for the US economy if it leads to continuing large budget deficits -saving-investment analysis suggests that governments must not forget about the long-run consequences of budget deficits in thinking about the use of fiscal stimulus packages to manage the economy

large v small open economies

-small open economy ignores the possible effects of changes in saving and investment in a large open economy on world interest rates -the difference b/w small and large economy frameworks is that shifts in saving and investment do affect the domestic real interest rate in a large open economy, but do not in a small open economy -in a large open economy, a rise in desired saving leads to a fall in the domestic interest rate, while a rise in desired investment leads to a rise in the domestic real interest rate -we can think of a large open economy as being a mix of a small open economy and a closed economy: the effect of shifts in saving and investment on the trade balance and net capital flows are the same as in a small open economy, while the effects on the domestic real interest rate and the actual levels of saving and investment are the same as in a closed economy

Summary Slides

1) Three saving measures figure prominently in macroeconomics: private saving (Sp = Y - T- C), gov saving (Sg = T - G), and national saving (S = Y - C - G = Sp + Sg), which is the sum of the other two. The uses-of-saving identity indicates that saving is linked to wealth because it either goes into investment, which adds to physical capital, or into net capital outflow, which adds to a country's net foreign assets. The net capital outflow identity says that net capital outflow, the difference between saving and investment, equals net exports: S - I = NX 2) In a closed economy, the goods market is in equilibrium when saving equals investment, S=I, at the intersection of the saving and investment curves. 3) An increase in saving (from a decrease in autonomous consumption, a decrease in government purchases, or an increase in taxes) shifts the saving curve to the right and leads to a lower real interest rate and higher saving and investment. An increase in autonomous investment shifts the investment curve to the right and leads to a rise in investment, saving and the real interest rate. 4) In an open economy, the domestic real interest rate equals the world real interest rate. Goods market equilibrium occurs when net exports equals saving minus investment: NX = S - I 5) Increases in work saving or decreases in work investment cause the domestic real interest rate to fall, domestic investment to rise, and net capital outflows (net exports) to fall 6) An increase in saving in a small open economy leads to a higher trade balance and an increase in net capital outflows. An increase in desired investment causes a decline in the trade balance and lowers net capital outflows. 7) A large open economy is a mix of a small open economy and a closed economy: the effects of shifts in saving and investment on the trade balance and net capital flows are the same as in a small open economy, while the effects on the domestic real interest rate and the actual amounts of saving and investment are the same as in a closed economy.

the amount consumers want to spend is a function of 3 factors:

1) autonomous consumption (C bar) : the amount of consumption expenditure that is unrelated to either disposable income or the real interest rate 2) disposable income (Y - T) 3) real interest rate (r) relationship of 3 factors: C = C(bar) + C*(Y - T, r) + - + indicates that as disposable income increases, C rises - indicates that as real interest rate rises, C falls as disposable income rises, consumers have more income to spend, increasing their desired amount of consumption expenditure

autonomous investment equation

As real interest rates fall, households and firms are more likely to make investments, and so the desired level of investment in the economy will rise. I = Ibar + I(r) - where Ibar is autonomous investment (investment unrelated to the real interest rate) and the minus sign below r indicates that as r increases, investment falls

balance of payments accounts

a bookkeeping system for recording all receipts and payments that have direct bearing on the movement of funds between a nation (private sector and government) and foreign countries, where the trade balance is periodically reported

national wealth

a country's holdings of assets minus its liabilities at a particular point in time

wealth

a person's holding of assets (such as bonds, stocks, houses, and fine art) minus his or her liabilities, the amount he or she owes (such as mortgages, car loans, and credit card balances)

changes in saving : autonomous consumption

a rise in autonomous consumption causes saving (S) and investment(I) to fall and the real interest rate (r) to rise in the long run while a fall in autonomous consumption causes saving (S) and investment (I) to rise and the real interest rate (r) to fall

response to a rise in saving in a small open economy

a rise in saving (either from a decline in autonomous consumption expenditure or a rise in government saving) shifts the saving curve from S1 to S2. With the world and hence the domestic real interest rate unchanged at r^w^1, the amount of desired saving increases from point B1 to point B2. At NX2, net exports rise, increasing the trade surplus and net capital outflows.

value-added tax

a tax that is paid by a producer on the difference between what it receives for its goods and services minus the costs

closed economy

an economy that is closed to international trade with zero net exports (NX = 0) -because nx=0, there are 3 components of GDP: consumption expenditure (C), investment (I), and government purchases (G) -total demand is C + I + G. if the goods market is in equilibrium, this demand will equal the amount of g/s produced (Y) goods market equilibrium occurs when Y = C + I + G S = Y - C - G = I Savings = Investment The real interest rate, inflation-adjusted cost of borrowing, keeps the market for saving and investment in equilibrium. This rate, which also describes the real benefit of saving, adjusts to maintain an equilibrium at which desired savings equals desired investment.

small open economy

an economy that is open to trade and to flows of capital across its borders and that is "small" relative to the world economy, so that whatever happens in this economy has no effect on the world real interest rate r^w

large open economy

an economy which is open to trade and capital flows, but are sufficiently large that their saving and investment decisions do influence the world real interest rate (i.e. United States or the Eurozone)

open economy

an economy which is open to trade and flows of capital across their borders

changes in saving : effects of fiscal policy

changes in fiscal policy--such as a change in taxes Tbar or government purchases Gbar can also affect the amount of desired saving at any given real interest rate and thus shift the saving curve taxes: a rise in taxes causes saving(S) and investment(I) to rise and real interest rate(r) to fall in the long run, while a fall in taxes causes saving(S) and investment(I) to fall and the real interest rate(r) to rise gov't purchases: a rise in government spending causes saving(S) and investment(I) to fall and the real interest rate(r) to rise in the long run, while a decline in gov spending causes saving(S) and investment(I) to rise and the real interest rate(r) to fall - crowding out gov't savings: increases in gov budget deficits (gov dissaving) causes saving(S) and investment(I) to fall in the long run and real interest rates(r) to rise because budget deficits can lead to crowding out of private I and higher r, attempts to use fiscal policy to stimulate the economy are very controversial

goods market equilibrium in a small open economy

equilibrium does not occur when saving equals investment, as in the closed economy. instead, it occurs when desired saving minus desired saving minus desired investment equals net exports

saving-investment diagram in a small open economy

equilibrium occurs when desired saving mins desired investment equals net exports at the world real interest rate. at the world real interest rate r^w^1, desired saving at point B is higher than desired investment at point A: the different between the two is a positive value of net exports. equilibrium in the goods market in a small open economy then occurs at a real interest rate of r^w^1, where the economy is running a trade surplus of NX1. At the world real interest r^2^w, investment now rises to point D and is greater than saving at point C, and net exports equals NX2, a negative number: there is a net capital inflow and a trade deficit. Figure 4.8

government investment (Ig)

government spending on capital goods like highways and schools that add to the capital stock and promote economic growth

government consumption (Cg)

government spending on current needs

response to a rise in investment tin a small open economy

if optimistic businesses decide to increase investment, the investment curve shifts to the right from I1 to I2. desired investment increases from point A1 to A2, and the difference between saving and investment now decreases, leading to a decline in net exports from NX1 to NX2 and a decrease in net capital outflows. An increase in autonomous investment causes a decline in the trade balance (the trade surplus to shrink or the trade deficit to increase) and lowers net capital outflows

connection between the world economy and the small open economy

increases in world saving (from a decline in world autonomous consumption expenditure, an increase in world taxes, or a decline in government spending throughout the world) or decreases in world investment cause the domestic real interest rate to fall, domestic investment to rise, and net capital outflows (net exports) to fall.

goods market equilibrium in an open economy

net exports NX will no longer be zero. the total demand for g/s in an open economy is therefore now equal to C + I + G + NX goods market equilibrium therefore occurs when: Y = C + I + G + NX therefore S = Y - C - G = I + NX saving = investment + net exports therefore NX = S - I net exports = saving - investment

government saving

net government income less government consumption. think of as taxes net of transfers (T) Sg = T - Cg G = Ig + Cg

in recent years

private savings has been at an all time low, the US government has been spending far more than it receives from tax revenue leading to large gov budget deficits and severely negative gov saving rates

investment tax credit

tax code which gives businesses a tax break when they make an investment in physical capital

uses-of-saving

tells us that saving either goes into investment--acquiring capital goods and boosting the capital stock--or, alternatively, into net exports--selling goods to foreigners in exchange for foreign currency assets - a nation that saves can invest in its capital stock or acquire assets from foreigners S = (C + I + G + NX) - C - G = I + NX

net capital overflow

the difference between saving and investment S - I = NX net capital outflow = trade balance ^^ the net capital outflow identity if saving is greater than investment, more capital flows from the domestic economy to foreigners than flows into the domestic economy from abroad. if investment is greater than saving, capital outflow is negative, aka capital inflow.

saving-investment diagram

the figure that we use to show the goods market equilibrium condition, S = I, that occurs at point E at the intersection of the saving and investment curves in Figure 5 (page 83) S>I so interest rates fall S<I so interest rates rise

budget surplus

the government's tax receipts minus its outlays, T - G - identical to government saving

net foreign assets

the net holdings of foreign assets (American-owned foreign stocks, bonds, bank accounts, factories, etc., minus foreign-owned US assets), an increase in foreign assets is clearly an increase in wealth - savings is linked to wealth - changes in wealth can affect saving

private saving

the percentage of income Americans tuck away each year private disposable income minus consumption expenditure YD = Y - T, (T = taxes minus government transfers minus interest payments on debt) private saving, Sp, as disposable income, Y-T, minus consumption expenditure, C: Sp = Y - T - C

twin deficits

the phenomenon of simultaneous trade deficit and government budget deficit 1970-2013 US government saving decline sharply from 1979 to 1983 when the government budget deficit went from under 2% of GDP to nearly 6% of GDP (the red bars). At the same time, the US economy began to display a large trade deficit (the purple bars), leading to the twin deficits. However, in the late 1990s during the Clinton Admin, both the fed and combined gov budget went into surplus, and yet the trade deficit continued to rise.

private saving rate

the proportion of private disposable income that is saved, Sp/YD

world real interest rate

the real interest rate found in world markets (rw) if the domestic real interest rate r were above the world real interest rate rw, then with no barriers to capital flows, domestic residents would just borrow abroad at the world real interest rate rw

national saving rate (S/Y)

the share of national income saved by the government and households note: savings (S) is national saving

national saving

the sum of private saving and government saving S = SP + Sg = Y - C - G national saving equals GDP minus spending on current needs, which include consumption expenditure and government purchases

saving

treat government fiscal policy as an exogenous variable : G = Gbar T = Tbar long-run aggregate output is therefore also an exo variable, we fix at Ybar Y = F(Kbar, Lbar) = Ybar substitute desired savings S = Ybar - Cbar - C(Ybar - Tbar, r) - Gbar note: 4 exogenous variables : Ybar, Cbar, Tbar, Gbar 4 endo variables : real interest rate (r), consumption (C), desired investment(I), desired saving (S) note: if r rises, C falls lower C means higher savings thus...r is negatively correlated with C, and C is negatively correlated with S. Hence, r is positively correlated with S.

trade deficit

when NX is negative, the trade balance is negative

trade surplus

when NX is positive, the trade balance is positive

perfect capital mobility

when an open economy does not have any restrictions on flows of capital between domestic and foreign residents or vice versa -with perfect capital mobility, the domestic real interest rate, r, must be the same as the world real interest rate r = rw

crowding out

when the rise in government spending causes private investment to fall as government spending increases