ECN 111 Chapter 9 Lecture Notes

ECN 111 Chapter 9 Lecture Notes

9.1 Capital, Investment, Wealth, and Saving

A. Capital and Investment

1. Physical capital is the tools, instruments, machines, buildings, and other constructions that have been produced in the past and are used to produce goods and services.

2. Financial capital is the funds firms use to buy and operate physical capital.

3. Gross investment is the total amount spent on new capital goods.

4. Net investment equals gross investment minus depreciation. The change in the quantity of capital is net investment.

B. Wealth and Saving

1. Wealth is the value of all the things that a person owns.

2. Saving is the amount of income that is not paid in taxes or spent on consumption goods and services. Saving adds to wealth.

C. Financial Markets

Financial markets are the collection of households, firms, governments, banks, and other financial institutions that lend and borrow.

D. Global Financial Markets

Financial markets are global.

1. Stock Markets

a. A stock is a certificate of ownership and claim to the profits that a firm makes.

b. A stock market is a financial market in which shares of companies’ stocks are traded. Examples include the New York Stock Exchange and the NASDAQ.

2. Bond Markets

a. A bond is a promise to pay specified sums of money on specified dates and is a debt for the issuer of the bond.

b. A bond market is a financial market in which bonds issued by firms and governments are traded.

3. Short-Term Securities Markets

a. Short-term securities are debt instruments, such as a commercial bill or a Treasury bill, which are financed over a period of a few months or less.

4. Loans Markets

a. Loans from banks are another way firms finance their short-term capital needs.

9.2 Investment, Saving, and Interest

A. Investment Demand

Others things remaining the same, the higher the real interest rate, the smaller is the quantity of investment demanded; and the lower the real interest rate, the greater is the quantity of investment demanded.

1. Investment Demand Curve

a. Investment demand is the relationship between the quantity of investment demanded and the real interest rate, other things remaining the same.

b. The investment demand curve is downward sloping, showing the negative relationship between the real interest rate and the quantity of investment demanded.

2. Changes in Investment Demand

When the expected profit changes, investment demand changes. Expected profit depends on:

a. Objective influences such as the phase of the business cycle, technological change, and population growth

b. Subjective influences, swings in optimism and pessimism (“animal spirits”).

c. Contagion effects, in which the optimism or pessimism spreads from one firm to the next (“irrational exuberance”).

3. Shifts of the Investment Demand Curve

When the expected profit increases, investment demand increases and the investment demand curve shifts rightward. When the expected profit decreases, investment demand decreases and the investment demand curve shifts leftward.

B. Saving Supply

Other things remaining the same, the higher the real interest rate, the greater is the quantity of saving supplied; and the lower the real interest rate, the smaller is the quantity of saving supplied.

1. Saving Supply Curve

a. Saving supply is the relationship between the quantity of saving supplied and the real interest rate, other things remaining the same.

b. The saving supply curve is upward sloping, showing the positive relationship between the real interest rate and the quantity of saving supplied.

2. Changes in Saving Supply

When any influence on saving other than the real interest rate changes, saving supply changes. The three main factors that influence saving supply are:

a. Disposable income. The greater a household’s disposable income, which is the income earned minus net taxes, the greater is its saving.

b. Buying power of net assets. The greater the buying power of net assets a household has accumulated, other things remaining the same, the less it will save.

c. Expected future disposable income. The higher a household’s expected future disposable income, other things remaining the same, the smaller is its saving today.

3. Shifts of the Saving Supply Curve

An increase in disposable income, a decrease in the buying power of net assets, or a decrease in expected future disposable income increases saving supply and shifts the saving supply curve rightward. A decrease in disposable income, an increase in the buying power of net assets, or an increase in expenditure future disposable income decreases saving supply and shifts the saving supply curve leftward.

C. Financial Market Equilibrium

The financial market is in equilibrium when the real interest rate is such that the quantity of saving supplied equals the quantity of investment demanded. There is neither a surplus nor a shortage of saving so that investors can get the funds they demand and savers can lend all the funds they have available.

9.3 Government in the Financial Market

A. Government Budget and Government Saving

In the global economy, I = S + (NT - G), where I is investment, S is saving, NT is net taxes, and G is government purchases.

a. (NT - G) is government saving.

b. When NT exceeds G, the government has a budget surplus and government saving is positive.

c. When NT is less than G, the government has a budget deficit and government saving is negative.

B. Effect of Government Saving

A government budget surplus increases total saving supply. The increase in saving supply brings a lower real interest rate, which decreases the quantity of private saving supplied and increases the equilibrium quantity of investment.

C. Government Deficit and Crowding Out

A government budget deficit decreases total saving supply. The decrease in saving supply brings a higher real interest rate, which increases the quantity of private saving supplied and decreases the equilibrium quantity of investment. The tendency for a government budget deficit to decrease investment is called the crowding-out effect.

1. The Ricardo-Barro effect says that a government deficit leads to a change in the supply of private saving that offsets the deficit, so that total saving supply is unchanged. As a result, the real interest does not change and investment is not crowded out.