Copyright © 2004 South-Western Hypothetical Market Adjustment to Great Leap Forward How would the GLF have worked in a market economy? Initiating event might have been Increased Govt expenditure for “defense”—promote steel production in remote locations Technology advance increasing profitability of small steel manufacturing, use of scrap steel, etc. Use the standard macro model to work through the impact of these initiating events.

Copyright © 2004 South-Western SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Y = C + I + G + NX (NFI)

Copyright © 2004 South-Western Some Important Relationships Now, subtract C and G from both sides of the equation: Y – C – G =I + NFI The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

Copyright © 2004 South-Western Summary National saving, or saving, can be expressed: S = I+NFI S = Y – C – G S = (Y – T – C) + (T – G)= NFI + I S = Private Saving + Public Saving

Copyright © 2004 South-Western The Market for Loanable Funds S = I + NFI uAt the equilibrium interest rate, the amount that people want to save plus what the government saves exactly balances the desired quantities of investment and net foreign investment.

Copyright © 2004 South-Western The Market for Loanable Funds Quantity of Loanable Funds Real Interest Rate Demand for loanable funds (for domestic investment and net foreign investment) Supply of loanable funds (from national saving) Equilibrium quantity Equilibrium real interest rate

Copyright © 2004 South-Western How Net Foreign Investment Depends on the Interest rate... 0 Net Foreign Investment Real Interest Rate Net foreign investment is positive. Net foreign investment is negative.

The Market for Foreign-Currency Exchange... Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net foreign investment) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate

(a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand Supply Quantity of Dollars Demand Supply Net Foreign Investment Net foreign investment, NFI Real Exchange Rate Real Interest Rate r1r1 E1E1 r1r1 The Real Equilibrium in an Open Economy

The Effects of Financing GLF with a Government Budget Deficit r2r2 r2r2 E2E2 1. A budget deficit reduces the supply of loanable funds... S2S2 B (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand S1S1 Quantity of Dollars Demand S1S1 S2S2 Net Foreign Investment NFI 5. …which causes the real exchange rate to appreciate. Real Exchange Rate Real Interest Rate 3....which in turn reduces net foreign investment. 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… r1r1 A E1E1 r1r which increases the real interest...

(a) The Market for Loanable Funds(b) Net Foreign Investment (China) (c) The Market for Foreign-Currency Exchange Quantity of Loanable Funds Demand Supply Quantity of Dollars Demand Supply Net Foreign Investment Net foreign investment, NFI Real Exchange Rate Real Interest Rate r1r1 E1E1 r1r1 An Increase in the Profitability of Backyard Steel Furnaces D2 E2 r2

What Actually Happened Backyard steel production and other projects were not profitable. Therefore, it was necessary to finance them through government procurement. In an open economy, this wasteful government expenditure might (temporarily) have been financed by investment from abroad. This at least temporarily would have reduced starvation, but would have paved the way for a future financial crisis if the foreign debt couldn’t be repayed.