National Income Accounts National saving-the total income in the economy that remains after paying for the consumption and government purchases.

Remember that GDP can be divided up into four components: consumption, investment, government purchases, and net exports.

National Savings To make the concept easy pretend we have a closed economy where no trade occurs. So for our GDP equation it would be Y=C+I+G

National Savings So Y=C+G+I To isolate investment, we can subtract C and G from both sides: Y-C-G=I Or GDP-Consumption-Government Purchases =Investment What is left is called national savings. Savings=Y-C-G=I Savings =Investing

You will have to keep reminding students what the term “investment” means to macroeconomists. Outside of the economics profession, most people use the terms “saving” and “investing” interchangeably. In macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings. (factories) If an individual spends less than he earns and uses the rest to buy stocks or mutual funds, economists call this saving.

Definition of National Saving (Saving): the total income in the economy that remains after paying for consumption and government purchases

Saving Continued Savings=GDP-Consumption-Govt Spending If T= Taxes and Transfer payments back to SS and Welfare It can be broken down also like this S=(Y-T-C) + (T-G) This breaks down into private savings and public savings

Private Saving: the income that households have left after paying for taxes and consumption. Public Saving: the tax revenue that the government has left after paying for its spending. Budget Surplus: an excess of tax revenue over government spending. Budget Deficit: a shortfall of tax revenue from government spending.

Breaking down National Savings S=(Y-T-C) + (T-G) Private Savings Public Savings Private Savings-is the amount of income that households have left after paying their taxes and paying for their consumption Public Savings-is the amount of tax revenue that the government has left after paying for it spending

Types of Savings Budget surplus-If govt receives more then they pay out. T-G is positive

Types of Savings Budget Deficit T-G is negative

The important point to make here is that with a government budget deficit, public saving is negative and the public sector is thus “dissaving.” To make up for this shortfall, it must go to the loanable funds market and borrow the money. This will reduce the supply of loanable funds available for investment.

THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the economy’s saving and investment in the market for loanable funds. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

Market for Loanable Funds To analyze how Government policies influence savings and investing we assume the economy has only one financial market and it is called the Market for Loanable funds.

Supply and Demand for Loanable Funds Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Supply and Demand for Loanable Funds Interest rate –the price of the loan –the amount that borrowers pay for loans and the amount that lenders receive on their saving –in the market for loanable funds, the real interest rate.

Supply and Demand for Loanable Funds Financial markets work much like other markets in the economy. The equilibrium of the supply and demand for loanable funds determines the real interest rate.

Supply is the Saver Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! Supply of loan able funds of people who have extra income they want to SAVE or Financial Investment!!!!! !!!!! Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! Notice as interest rates go up people are willing to save more (invest Financially) Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! This would be a Dot to Dot Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! If interest Rates go down what will people do? Save less. I would rather do something else with my money then put it in the bank because it isn’t earning much interest Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! The curve will shift if something besides interest rate change makes you want to save more or less. Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! For example if the government cuts taxes on interest income Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! Because you will actually make more money from saving that would make you want to save more so the curve shifts right! Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! If the Government raises taxes on Investment income (like Obama Wants to) What will that cause people to do? Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds

Lets look at it! Save Less Real Interest Rates 3% 5% 10% $100 $200 $300 Quantity of Loanable funds s2

The supply of loanable funds comes from those who spend less than they earn. The supply can occur directly through the purchase of some stock or bonds or indirectly through a financial intermediary.

This Is Very Important You will have to keep reminding students what the term “investment” means to macroeconomists. Outside of the economics profession, most people use the terms “saving” and “investing” interchangeably. In macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings. (factories) If an individual spends less than he earns and uses the rest to buy stocks or mutual funds, economists call this saving.

Demand is the Borrower! D Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D Demand comes from households and businesses that need money for investments in factories or a person wanting to buy a house. Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D If interest Rates are low that encourages people to take out more loans to expand or create new businesses Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D Right now interest rates are around 4% and people still aren’t buying houses. Normal interest rates are around 7%. Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D IF interest Rates Rise that stops people from wanting to borrow as much money Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D That because you not only have to pay back the loan but you also have to pay back the interest. Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D If you want to borrow more money besides the interest rates changing the curve will shift! Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D For example if the Government gives you a tax break(subsidy) for starting a new business. Borrowing would go up! Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D Last year the government was giving tax breaks to new home buyers of up to $7,500 and home sales rose! Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D What happened when the government took the tax break away? Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds

Lets look at it! D You guessed it! Real Interest Rates 5% 10% 3% $100 $200 $300 Quantity of Loanable funds Housing sales in July plunged 25.5 percent below the level of a year ago, the National Association of Realtors said on Tuesday, as buyers lost the spur of a government tax credit National Association of Realtors

The demand for loans comes from households and firms who wish to borrow funds to make investments. Families generally invest in new homes while firms may borrow to purchase new equipment or to build factories.

Lets look at it! D S Interest Loanable funds Supply of loanable funds comes from saving and the demand for loanable funds comes from investment

Loanable Funds (in billions of dollars) 0 Interest Rate Demand Supply 5% $1,200 Market for Loanable Funds...

Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment –Taxes and saving –Taxes and investment –Government budget deficits and surpluses

Policy 1: Saving Incentives Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. A tax decrease increases the incentive for households to save at any given interest rate. –The supply of loanable funds curve shifts right. –The equilibrium interest rate decreases. –The quantity demanded for loanable funds increases.

Figure 2 An Increase in the Supply of Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate Supply,S1S1 S2S which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Demand 1. Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600

S2S2 1. Tax incentives for saving increase the supply of loanable funds... An Increase in the Supply of Loanable Funds... Loanable Funds (in billions of dollars) 0 Interest Rate 5% Supply, S 1 $1,200 Demand $1, and raises the equilibrium quantity of loanable funds. 4% 2....which reduces the equilibrium interest rate... Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Policy 1: Saving Incentives If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved.

Policy 2: Investment Incentives If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

An Increase in the Demand for Loanable Funds... Loanable Funds (in billions of dollars) 0 Interest Rate 5% $1,200 Supply Demand, D 1 1. An investment tax credit increases the demand for loanable funds... D2D2 6% 2....which raises the equilibrium interest rate... $1, and raises the equilibrium quantity of loanable funds. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Figure 3 Investment Incentives Increase the Demand for Loanable Funds Loanable Funds (in billions of dollars) 0 Interest Rate 1. An investment tax credit increases the demand for loanable funds which raises the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Supply Demand,D1D1 D2D2 5% $1,200 6% $1,400

Policy 3: Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. The accumulation of past budget deficits is called the government debt.

Budget Deficit Budget Surplus-

Policy 3: Government Budget Deficits and Surpluses Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as Crowding Out EFFECT –The deficit borrowing crowds out private borrowers who are trying to finance investments.

Crowding out effect-govt taking all the money so cost families more to borrow because there is less money available.

Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.

Figure 4: The Effect of a Government Budget Deficit Loanable Funds (in billions of dollars) 0 Interest Rate and reduces the equilibrium quantity of loanable funds. S2S which raises the equilibrium interest rate... Supply,S1S1 Demand $1,200 5% $800 6% 1. A budget deficit decreases the supply of loanable funds...

S2S2 1. A budget deficit decreases the supply of loanable funds... The Effect of a Government Budget Deficit... Loanable Funds (in billions of dollars) 0 Interest Rate $1,200 Supply, S 1 Demand 5% $ and reduces the equilibrium quantity of loanable funds which raises the equilibrium interest rate... 6% Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Policy 3: Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls. A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

Loanable Funds (in billions of dollars) 0 Interest Rate Demand Supply 5% $1,200 Market for Loanable Funds. Government Surplus.. Supply

Figure 5 The U.S. Government Debt Percent of GDP Revolutionary War 2010 Civil War World War I World War II

The U.S. financial system is made up of financial institutions such as the bond market, the stock market, banks, and mutual funds. All these institutions act to direct the resources of households who want to save some of their income into the hands of households and firms who want to borrow.

National income accounting identities reveal some important relationships among macroeconomic variables. In particular, in a closed economy, national saving must equal investment. Financial institutions attempt to match one person’s saving with another person’s investment.

The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income. The demand for loanable funds comes from households and firms who want to borrow for investment.

National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP.

Real Interest Rate, (percent) Quantity of Loanable Funds [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [* Use the Money Market graph when there is a change in MS ] r=6%r=6%r=6%r=6% D1D1D1D1 F1F1F1F1 S balanced budget Starting from a balanced budget, if the G incr spendingdecr T G incr spending or decr T to get out of recession a recession, they would now be running deficitpushing a deficit and have to borrow, pushing up demand in the LFMincreasing up demand in the LFM and increasing the real interest rate the real interest rate. D2D2D2D2 r=8%r=8%r=8%r=8% F2F2F2F2 E1E1E1E1 E2E2E2E2 Borrowers Lenders $ 2 T ril. G T Balanced Budget [G&T=$2 Tril.] $2.2 T ril. $2 T ril. $2 T ril. “real interest rate” Use the “real interest rate” with LFMlong-term LFM, because it is long-term. “nominal interest rate” Use “nominal interest rate” with money marketshort-term money market, as it is short-term. $1.8 T ril. $1.8 T ril.

Real Interest Rate, (percent) Quantity of Loanable Funds r=6%r=6%r=6%r=6% D F1F1F1F1 S1S1S1S1 r=4%r=4%r=4%r=4% F2F2F2F2 E1E1E1E1 E2E2E2E2 Borrowers Lenders S2S2S2S2 T he following would cause an increase in supply in the LFM and lower real interest rates: 1. Fed increases MS 2. HH save more 3. Business save more 4. Government saves more 4. Foreigners save more here [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [* Use the Money Market graph when there is a change in MS ]

Demand for Loanable Funds Market (a) (b) Demand for L oanable Funds at 3 % [no G borrowing] Business firms demand for L oanable Funds at 3 % [a lot of investment] Rate Interest 3% S D 1[ no G] LFM A A Trillions of Dollars 3% 1.5 Trillions of Dollars QID DIDI Low interest rates, so - a lot of investment Real

Demand for Loanable Funds Market (a) (b) Rate Interest 3% S D 1[ no G] LFM A Trillions of Dollars 3% 1.5 Trillions of Dollars DIDI With “G” borrowing, the demand for LF goes to 5 % Business firms d emand for Loanable Funds at 5 % [not as much investment] D 2 (G) 5% QID1 Higher interest rates, so not as much investment 1.0 Government Demand for Funds Business Demand for Funds A B Real B 5%5%5%5% QID2 QID2

Real Interest Rate, (percent) r=6%r=6%r=6%r=6% D1D1D1D1 F1F1F1F1 S D2D2D2D2 r=8%r=8%r=8%r=8% F2F2F2F2 E1E1E1E1 E2E2E2E2 Borrowers Lenders $ 2 T G T Balanced Budget [G&T=$2 Tr.] $2.1 Tril. after $100 B increase $2 T $2 T 1.(a) Using a correctly labeled graph of the loanable funds market, show the impact of an increase in government spending on the real interest rate [RIR] in the economy. 1.(b) How will this real interest rate change affect the growth rate of the U.S. economy? Explain. Answer to 1. (a) Answer to 1. (a) As can be seen on the LF graph, the RIR would increase as the government has to borrow As can be seen on the LF graph, the RIR would increase as the government has to borrow more than previously, increasing demand in the LFM, which pushes up the RIR. more than previously, increasing demand in the LFM, which pushes up the RIR. Answer to 1. (b): The increase in RIR will decrease real Ig, decreasing capital stock. This will decrease AD and decrease GDP or growth rate in the U.S. economy.

[3pts] correctly labeled graph of the loanable funds market [3pts] Using a correctly labeled graph of the loanable funds market, decision by households to increase saving for show how a decision by households to increase saving for retirementaffect the real interest rate retirement will affect the real interest rate in the short run. F1F1 r1r1 Quantity of Loanable Funds D S1S1 E1E1 Real Interest Rate, (percent) S2S2S2S2 r2r2r2r2 E2E2E2E2 Answer: If householders save more the banks have more money to loan out [S 2 ] which would decrease the real interest rate [to r2]. loan out [S 2 ] which would decrease the real interest rate [to r2]. F2F2F2F2 [3 points showing correctly labeled graph, showing increase in supply & real I.R. dropping.]

6 pts 2. [6 pts] Assume that as a result of increased political instability, investors move their funds out of the country of Tara. 2 pts (a) [2 pts] How will this decision by investors affect the international value of Tara’s currency on the foreign exchange market? Explain. 2 ptsloanable funds market in Tara (b) [2 pts] Using a graph of the loanable funds market in Tara, show the impact of foreign investors pulling money out on Tara on their real interest rates. 2 pts (c) [2 pts] Given your answer in part b, what will happen to Tara’s rate of economic growth? Explain. Answer to 2. (a) As foreign investors pull their money out of Tara, there would be a decrease in demand for their currency, which would depreciate their currency. [ 2 pts for saying their currency depreciates because demand for it decreases.] S1S1 D r1 F1F1F1F1 Real Interest Rate, (%) Quantity of Loanable Funds E1 r2r2r2r2 F2F2F2F2 E2E2E2E2 S2S2S2S2 LFM Answer to 2. (b) As can be seen on the graph, as foreign As can be seen on the graph, as foreign investors pull their money out of Tara, investors pull their money out of Tara, there is a decrease in their supply of there is a decrease in their supply of loanable funds [1 pt], increasing the RIR loanable funds [1 pt], increasing the RIR [1 pt]. [1 pt]. Answer to 2. (c) As the RIR increases, it becomes less profitable for firms to invest in capital equipment, which decreases economic growth. [1 point for decrease in growth rate and 1 point for decrease in capital formation {can’t just say “investment”}, but capital formation or equipment.]

S D1D1 r1 F1F1F1F1 Real Interest Rate, (%) Quantity of Loanable Funds E1 r2r2r2r2 F2F2F2F2 E2E2E2E2 D2D2D2D2 LFM Answer to 1. B. (i) [1 pt] The higher RIR will result in less investment in tools and machinery. 1. B. (ii) [1 pt] The decrease in tools and machinery will decrease overall 1. B. (ii) [1 pt] The decrease in tools and machinery will decrease overall productivity and economic growth [capital stock]. productivity and economic growth [capital stock]. 1. A. [2 pts] In order to finance an increase in government spending on national defense, the government borrows funds from the public. Using a correctly labeled graph of the loanable funds market, show the effect of the government’s borrowing on the real interest rate. B. [2 pts] Given the change in the real interest rate in part (d), what is the impact on each of the following? (i) Investment (ii) Economic growth rate. Explain. Answer to 1. A. 1 pt for correctly labeled graph of the LFM. 1 pt for showing a rightward shift of the demand curve resulting in a higher interest rate OR a leftward shift of the supply curve resulting in a higher RIR.