Econ 1250 In class A4 – Ch 10 Q1. a) Given the following information about a closed economy, calculate the level of investment spending, private savings, and the budget balance. What is the relationship among the three? Is National Saving equal to Investment spending? (There are no Government Transfers) C= $850 million T= $50 million GDP= $1000 million G= $100 million.
Q2.Using the Loanable funds market diagram, Explain what happens to Private savings, private investment spending and the interest rate if each of the following events occur. Assume there are no capital inflows or outflows. a. The government runs a budget surplus. b. Businesses become very optimistic about future profitability of investment spending at any given interest rate. Assume the budget balance is zero.
Q3. Ali and Barb agree that Ali will lend Barb $1000 and Barb will repay the amount in one year with interest. The nominal interest rate they agree on is 6%, reflecting a real interest rate of 3% with a commonly held expectation of inflation rate of 3% over the next year. If inflation rate is actually 4% (higher than expected) how does that affect Ali and Brab? Who is better off? Explain. 3 Q4 If the domestic interest rate is higher in Ghana than the domestic interest rate in Swaziland, using the market for loanable funds in an open economy with free flow of capital, determine: i. What happens to interest rate in each economy over time ii. Which economy will see a net capital inflow iii. Which economy will see a net capital outflow iv. In terms of Net lender or net borrower, what can you say about the two economies in the long run. Explain with tbe help of diagrams.
In Macroeconomics, investment spending refers to the amount of money invested in the purchase of capital goods. In this context, capital goods are assets used to produce other goods and services and may include machinery and vehicles. The level of investment spending in a country can be calculated using the Gross Domestic Product (GDP) formula: GDP= C + I + G + NX
Therefore, Investment spending= GDP- (C + G + NX). In this case, $1000million- ($850million+ $100million).
Therefore, investment spending is $50million.
Private savings represent the portion of income that the households of a country remain with after making tax provisions and spending on consumption. Private savings can be calculated in two steps. Step One: Calculate the disposable income
Disposable income= GDP – Taxes + Transfers ($1000million – $50million+ 0)
Disposable income is $950million
Step Two: Calculate Savings
Savings= Disposable income – consumption ($950million- $850million)
Private savings is $100million
Budget balance refers to the amount of revenue and expenses incurred by the national government. The budget balance can be calculated using the formula: Government expenditure – Government revenue ($100million- $50million). Therefore, the budget balance is $50million
The primary relationship between the three factors is that investment spending equals private savings minus the budget balance. This relationship is evident in the case scenario, whereby investment spending ($50million) is equal to private savings ($100million)- budget balance ($50million).
National saving can be calculated using the formula: (Income + consumption)/income. In this case, ($950million + $850million)/ $950million= $950million. Therefore, national saving ($950million) is not equal to investment saving ($50million).
- If the selected economy is an open economy, there would be imports and exports in and out of the country. The trade, in and out of the economy, would not affect private savings and budget balance. However, the investment spending would be affected significantly as more capital is invested in capital goods to promote more exports.
For example, the new investment spending would be: GDP- (C + G + NX) = $1000 – ($850 + $100 – $25). Investment spending would be $75million.
In this scenario, Investment spending ($75million) is equal to the sum of personal savings ($50million) and net exports ($25million).
In the event where the government runs a budget surplus, it means that there are extra funds for the government to spend on aspects such as national projects. The budget surplus also means that the government does not need to use loanable funds from savers to settle federal borrowing, which, in turn, increases the amount of loanable funds available for private investors. Furthermore, due to the adequate supply of loanable funds, lenders may lower their lending interest rates, thus encouraging more investment spending to be done in the country. Besides, households may adjust savings according to the nature of the budget. In this context, a budget surplus would mean that a tax cut would be experienced in the country, thus make savings less attractive. Therefore, savings would reduce significantly in the event of a budget surplus, as illustrated in figure 1.
Figure1: Loanable Funds Market Diagram in the event of a budget surplus
As shown in the diagram, when the government runs a budget surplus, interest rates reduce from r0 to r1, savings decline from S0 to S1, and investment increases from I0 to I1.
If businesses become very optimistic about the future profitability of investment spending at any given interest rate, with the budget balance at zero, investment spending increases, and the interest rates are likely to increase significantly due to increased demand for loanable funds, as shown in figure 2. However, private savings may not be substantially be affected by this event.
As can be seen in figure 2, when businesses become very optimistic about future profitability and investment spending, the demand for loanable funds increases from D0 to D1, which in turn triggers a rise in the interest rate from r0 to r1.
A rise or decline in the expected inflation rate is likely to affect borrowers and lenders in a given economy. In this case scenario, a higher rate of inflation than expected is likely to subject the lender (Ali) to loses. On the other hand, Barb (the borrower) would benefit from the change in inflation. Therefore, Barb would be better off in this scenario because he would repay the money at a lower realized real interest rate than the contracted interest rate.
- If the domestic interest rate in Ghana is higher than that of Swaziland in an open economy, the interest rate of each economy is likely to rise over time due to capital inflows and availability of loanable funds. Most notably, the higher interest rate in Ghana is expected to attract investors from Swaziland, thus reducing the supply of loanable funds in the latter. In turn, the low supply of loanable funds may compel lenders in Swaziland to demand higher lending interest rates, as shown in figure 3. Therefore, the interest rates of both economies are likely to equalize over time.
As can be seen in figure 3, a decrease in the quantity of loanable funds in Swaziland leads to a rise in the interest rate from r 0 to r 1, thus creating an equilibrium of interest rates in both countries over time.
- As noted, both Ghana and Swaziland operate as open economies, which means that there lacks control over capital flow in both countries. Therefore, Ghana is likely to see a net capital inflow as investors will be more attracted to its assets, which have a higher interest rate and returns.
- On the other hand, Swaziland will see a net capital outflow as investors direct their money in other countries with higher interest rates and returns.
- In terms of the net borrower, I would say that the two economies would be suitable for loan capital in the long run. As noted, the interest rates of both economies would eventually equalize due to the reduced supply of loanable funds in Swaziland. Ultimately, borrowing either in Ghana or Swaziland would attract a high interest rate for the net borrower in the long run.
Food for Thought
The statement “gains from trade are only possible if two nations have different opportunity costs” is incorrect because there are diverse sources of gains from trade. Among the sources of gains from trade proposed by David Ricardo is specialization. Most notably, when a country specializes in producing a given commodity, it incurs less production cost compared to another country that tries to produce the same item on a small scale. Therefore, gains from trade in specialization arise from the comparative conditions whereby one country saves on domestic production by importing from another country specializing in producing the same good. Furthermore, gains from trade are also possible if two countries invest in the division of labor, which means that the statement is incorrect.