Macro Chapter 8

A closed economy has income of $1,000, government spending of $200, taxes of $150, and investment of $250. What is private saving?

$300

Higher Interest Rate Bond Examples

A bond of an Eastern European government as opposed to the US government A bond that repays the principal in year 2040 as opposed to 2020 A bond from a software company you run in your garage as opposed to a bond from coca cola A bond issued by the federal government as opposed to a bond issued by the state

A school opens up a market for loanable funds in which students can borrow and lend among themselves at an interest rate r

A student would choose to be a borrower in this market if his or her expected rate of return is GREATER than r

Money a Year Later = Money Today x (1 + Rate of return) *Assume borrowing and lending is prohibited

Ex: $ = 1,000 RoR: 5 money a year later = $1,000 x ( 1 + .05) OR $1,000 x (1,000x .05) money a year later = $1,050

Instead of investing in the factory, Intel could use the money to purchase bonds and earn the higher interest rate available there. Intel will compare its potential returns from building the factory to the potential return from the bond market.

If interest rates rise, so that bond market returns rise, Intel is again less likely to invest in the factory.

Term

Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. To compensate for this risk, long-term bonds usually pay higher interest rates than short-term bonds.

Investment

Refers to the purchase of new capital, such as equipment or buildings Ex: When a person or firm purchased new capital. Your family takes out a mortgage and buys a new house. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business.

In a closed economy (that is, an economy that does not trade with the rest of the world), total or national saving (private and public) must equal investment S = I

S = I S: Total/ National saving S: Private Saving + Public Saving I: investment

If a popular TV show on personal finance convinces more Americans about the importance of saving for retirement, the ________ curve for loanable funds would shift, driving the equilibrium interest rate ________.

Supply, Down

There are many different bonds in the world economy, and these bonds differ according to three characteristics

Term Credit Risk Tax Treatment

Private Saving Extended

is the amount of income that households have left after paying their taxes and paying for their consumption Ex: When a person's income exceeds his consumption. You use your $200 paycheck to buy stock in AT&T. Your roommate earns $100 and deposits it in his account at a bank.

Public Saving

is the amount of tax revenue that the government has left after paying for its spending, T - G

If the government collects more in tax revenue than it spends, and households consume more than they get in after-tax income, then

private saving is negative, but public saving is positive.

Bondholders

receive a fixed interest payment, regardless of the company's profitability loans money, interest rate generates profit

Stockholders

share in the profits of a corporation, offering both higher risk and potentially higher reward than bonds loans money, gets a fraction of profit

Public Saving is POSITIVE when Public saving is NEGATIVE when

the government collects more in taxes than it spends (T > G) the government spends more than it collects in taxes (T < G)

If the expected rate of return is LESS than r

the student will lend

The equilibrium interest rate is determined by the intersection of the supply and demand curves in the market for loanable funds. Saving makes up the supply of loanable funds

therefore, an increase in saving shifts the supply curve for loanable funds to the right. This drives the equilibrium interest rate down.

Even If Intel has enough of its own funds to build the new factory without borrowing, an increase in interest rates STILL affects Intel's decision about whether to build the factory.

Even if Intel uses its own funds to build the factory, the rise in interest rates still matters. There is an opportunity cost on the use of the funds.

If the business community becomes more optimistic about the profitability of capital, the ________ curve for loanable funds would shift, driving the equilibrium interest rate ________.

Demand, Up

The more profitable capital becomes, the more firms are rewarded for borrowing money to invest in new capital.

Thus if capital is perceived as more profitable, the demand curve for loanable funds would shift to the right, driving the equilibrium interest rate up.

Credit Risk

When bond buyers perceive that the probability of default is high, they demand a higher interest rate as compensation for this risk.

Tax Treatment

When state and local governments issue bonds, the bond owners are not required to pay federal income tax on the interest income. Because of this tax advantage, bonds issued by state and local governments typically pay a lower interest rate than bonds issued by corporations or the federal government.

National saving consists of income that is left after subtracting consumption and government spending Y - C - G

Y:

Money a Year Later = Money Today x (1 + Rate of return) - Money Borrowed x (1 + Borrowed Int. Rate)

Your $ = $1,000 Your rate of return = 20% You borrow $1,000 SO money today will = $2,000 Int rate is 8% $2,000 (1 + .2) - $1,000 (1 + .08) Money a year later after paying borrowed interest rate = $1320

Private saving is NEGATIVE when Private saving is POSITIVE when

consumption is greater than after-tax income (C > Y - T) after-tax income is greater than consumption (C < Y - T )

Suppose that Intel is considering building a new chip-making factory. Assuming that Intel needs to borrow money in the bond market, an increase in interest rates affects Intel's decision about whether to build the factory, because now the cost of borrowing money becomes

higher If interest rates increase, the cost of borrowing money to build the factory becomes higher, so the returns from building the new plant may not be sufficient to cover the costs. Thus, higher interest rates make it less likely that Intel will build the new factory.

An increase in government borrowing

increase the interest rate will reduce the supply of loanable funds the supply curve will shift left new equilibrium rate will rise

From 2008 to 2012, the ratio of government debt to GDP in the United States

increased markedly As the economy was experiencing a financial crisis and deep recession in 2008, the debt-to-GDP ratio in the United States increased markedly

When interest rate increases

investment and national saving DECLINE and private saving INCREASES

Private Saving

is the amount of income households have left after paying their taxes and paying for their consumption, or Y - T - C