ECO5POE S1 2013

Tutorial 8 Answers
Chapter 21: Finance, Saving, and Investment
Michael is an Internet service provider. On 31 December 2011, he bought an existing business with servers and a building worth $400,000. During his first year of operation, his business grew and he bought new servers for $500,000. The market value of some of his older servers fell by $100,000. Question 1 What was Michaels gross investment, depreciation, and net investment during 2012? Michaels gross investment was $500,000, his depreciation was $100,000, and his net investment was $400,000. Question 2 What is the value of Michaels capital at the end of 201 2? Michaels capital at the end of 2012 is equal to his capital at the beginning of 2012, $400,000, plus his net investment during the year, also $400,000, for a total of $800,000. Question 8 Draw a graph to illustrate how an increase in the supply of loanable funds and a decrease in the demand for loanable funds can lower the real interest rate and leave the equilibrium quantity of loanable funds unchanged. Figure 7.2 shows the effect of an increase in the supply of loanable funds and a decrease in the demand for loanable funds. The supply of loanable funds curve shifts rightward from SLF0 to SLF1, and the demand for loanable funds curve shifts leftward from DLF0 to DLF1. The magnitude of the increase in supply is equal to the magnitude of the decrease in demand, so the real interest rate falls (from 7 percent to 4 percent in the figure) and the quantity of loanable funds does not change (staying at $2.5 trillion in the figure).

ECO5POE S1 2013

Use the table to work Problems 10 to 12. The table shows an economys demand for loanable funds and the supply of loanable funds schedules, when the governments budget is balanced.

Real interest rate (percent per year) 4 5 6 7 8 9 10

Loanable funds demanded

Loanable funds supplied

(billions of 2009/10 dollars) 8.5 8.0 7.5 7.0 6.5 6.0 5.5 5.5 6.0 6.5 7.0 7.5 8.0 8.5

Incidentially, when the government budget is balanced: The equilibrium real interest rate is 7% 2

ECO5POE S1 2013

The quantity of private investment is $7.0 billion (from the demand curve) The quantity of private saving is $7.0 billion (from the supply curve) Question 10 Suppose that the government has a budget surplus of $1 billion. What are the real interest rate, the quantity of investment, and the quantity of private saving? Does any crowding out occur?

Real interest rate (percent per year) 4 5 6 7 8 9 10

Loanable funds demanded

Loanable funds supplied

(billions of 2009/10 dollars) 8.5 8.0 7.5 7.0 6.5 6.0 5.5 6.5 7.0 7.5 8.0 8.5 9.0 9.5

(For a graphical representation you can consult Fig 21.7 in the text) Given that the government is running a budget surplus, its participation in the loanable market will increase the supply. Hence add $1 billion to the loanable funds supply column. The equlibrium real interest rate is 6% The quantity of investment is $7.5 billion (from the demand curve) The quantity of private saving is $6.5 billion To see this, the total saving from the supply curve is $7.5 billion the $1.0 billion budget surplus = $6.5 billion private saving There is no crowding out (since investment is higher)

ECO5POE S1 2013

Question 11 Suppose that the government has a budget deficit of $1 billion. What are the real interest rate, the quantity of investment, and the quantity of private saving? Does any crowding out occur?

Real interest rate (percent per year) 4 5 6 7 8 9 10

Loanable funds demanded

Loanable funds supplied

(billions of 2009/10 dollars) 9.5 9.0 8.5 8.0 7.5 7.0 6.5 5.5 6.0 6.5 7.0 7.5 8.0 8.5

Given that the government is running a budget deficit, its participation in the loanable market will increase the demand. Hence add $1 billion to the loanable funds demand column. (For a graphical representation you can consult Fig 21.8 in the text) The equilibrium real interest rate is 8% The quantity of private investment is $6.5 billion To see this, the total investment from the demand curve is $7.5 billion the $1.0 billion budget deficit = $6.5 billion private investment The quantity of private saving is $7.5 billion (from the supply curve) There is crowding out of $500 million of investment. To see this, when budget was balanced, private investment was $7.0 billion, now compared with $6.5 billion with budget deficit

ECO5POE S1 2013

Question 12 Suppose that the government has a budget deficit of $1 billion and the Ricardo-Barro effect occurs, what are the real interest rate and the quantity of investment?

Real interest rate (percent per year) 4 5 6 7 8 9 10

Loanable funds demanded

Loanable funds supplied

(billions of 2009/10 dollars) 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.5 7.0 7.5 8.0 8.5 9.0 9.5

(For a graphical representation you can consult Fig 21.9 in the text) The Ricardo-Barro effect states that when the government runs a budget deficit of $1 billion, rational taxpayers will expect that future taxes to be higher to bring the budget back to balance and hence future disposable income to be lower. As a result, saving increases today. Therefore add $1 billion to both the loanable funds demand and supply columns. The equilibrium real interest rate remains 7% The quantity of private investment remains $7.0billion To see this, the total investment from the demand curve is $8.0 billion the $1.0 billion budget deficit = $7.0billion private investment There is no crowding out because the $1 billion increase in the budget deficit leads to an offsetting $1 billion increase in private saving

ECO5POE S1 2013

Use the following information to work Problems 16 and 17. Global Saving Glut and U.S. Current Account, remarks by Ben Bernanke (when a governor of the Federal Reserve) on March 10, 2005: The U.S. economy appears to be performing well: Output growth has returned to healthy levels, the labour market is firming, and inflation appears to be under control. But, one aspect of U.S. economic performance still evokes concern: the nations large and growing current account deficit [negative net exports]. Most forecasters expect the nations current account imbalance to decline slowly at best, implying a continued need for foreign credit and a concomitant decline in the U.S. net foreign asset position. Question 16 Why is the United States, with the worlds largest economy, borrowing heavily on international capital marketsrather than lending, as would seem more natural? At the world real interest rate the quantity of loanable funds demanded in the United States exceeds the quantity of loanable funds supplied. The surprising aspect of this point is that the quantity of loanable funds is low in the United States because U.S. disposable income is so high. Investment is funded by household saving, the government budget surplus, and borrowing from the rest of the world, so that I = S + (T G) + (M X). Foreigners might be eager to make investments in the United States, perhaps because the investment is more productive or perhaps safer than elsewhere in the world. If this is the situation, then the supply of loanable funds by foreigners to the United States is greater than would otherwise be the case, which would lead to a lower U.S. real interest and a greater quantity of funds borrowed from abroad. Question 17 a. What implications do the U.S. current account deficit (negative net exports) and our reliance on foreign credit have for economic performance in the United States? The United States is borrowing from abroad to meet the demand for loanable funds. With the borrowing, the quantity of loanable funds in the United States is larger than otherwise, which means that the quantity of investment projects funded is larger than otherwise. As a result, the U.S. capital stock is larger than otherwise, which helps enhance U.S. economic performance. However, the United States will need to repay 6

ECO5POE S1 2013

its loans from the rest of the world and this repayment will detract from U.S. citizens well-being. b. What policies, if any, should be used to address this situation? If the goal is to reduce U.S. borrowing from abroad, then either the U.S. demand for loanable funds needs to decrease or the U.S. supply of loanable funds needs to increase. Increasing the quantity of U.S. loanable funds seems to be the more reasonable policy, so policy proposals need to focus on increasing savings. Government policies to boost private saving might include tax policies that exempt the return from saving from taxation. Additionally government policies that decrease the size of the budget deficit and perhaps move the government budget to a surplus also would decrease U.S. borrowing from abroad.