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C h a p t e r

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FINANCE, SAVING,
AND INVESTMENT

Answers to the Review Quizzes


Page 548
1.

Distinguish between physical capital and financial capital and give two examples of each.
Physical capital is the actual tools, instruments, machines, buildings and other items that have been
produced in the past and are presently used to produce goods and services. Financial capital is the funds
that businesses use to acquire their physical capital. Examples of physical capital are the pizza ovens owned
by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of financial capital are the
bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund their purchases of
new buildings.

2.

What is the distinction between gross investment and net investment?


Gross investment is the total amount spent on new capital; net investment is the change in the capital
stock. Net investment equals gross investment minus depreciation.

3.

What are the three main types of markets for financial capital?
The main types of markets for financial capital are the loan markets, the bond markets, and the stock
markets.

4.

Explain the connection between the price of a financial asset and its interest rate.
There is an inverse relationship between the price of a financial asset and its interest rate. When the price
of a financial asset rises, its interest rate falls. Similarly, when the interest rate on an asset falls, the price of
the asset rises.

Page 553
1.

What is the market for loanable funds?


The market for loanable funds is the market in which households, firms, governments, banks, and other
financial institutions borrow and lend. It is the aggregate of all the individual financial markets and
includes loan markets, bond markets, and stock markets. The real interest rate is determined in this
market.

2.

Why is the real interest rate the opportunity cost of loanable funds?
The real interest rate is the opportunity cost of loanable funds because the real interest rate measures what
is forgone by using the funds. If the funds are loaned, then the real interest rate is received. If the funds are
borrowed, then the real interest is paid for the funds. The real interest rate forgone when funds are used
either to buy consumption goods and services or to invest in new capital goods is the opportunity cost of
not saving or not lending those funds.

3.

How do firms make investment decisions?


To determine the quantity of investment, firms compare the expected profit rate from an investment to the
real interest rate. The expected profit from an investment is the benefit from the investment. The real
interest rate is the opportunity cost of investment. If the expected profit from an investment exceeds the

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CHAPTER 23

cost of the real interest rate, then firms make the investment. If the expected profit from an investment is
less than the cost of the real interest rate, then firms do not make the investment.

4.

What determines the demand for loanable funds and what makes it change?
The demand for loanable funds depends on the real interest rate and expected profit. If the real interest
rate falls and nothing else changes, the quantity of loanable funds demanded increases. Conversely, if the
real interest rate rises and everything else remains the same, the quantity of loanable funds demanded
decreases. Movements along the loanable funds demand curve illustrate these events. If the expected profit
increases and nothing else changes, the demand for loanable funds increases and the demand for loanable
funds curve shifts rightward. If the expected profit decreases and everything else remains the same, the
demand for loanable funds decreases and the demand for loanable funds curve shifts leftward.

5.

How do households make saving decisions?


A households saving depends on five factors: the real interest rate, the households disposable income, the
households expected future income, wealth, and default risk. A household increases its saving if the real
interest rate increases, its disposable income increases, its expected future income decreases, its wealth
decreases, or if default risk decreases.

6.

What determines the supply of loanable funds and what makes it change?
The supply of loanable funds depends on the real interest rate, disposable income, expected future income,
wealth, and default risk. An increase in the real interest rate increases the quantity of loanable funds
supplied; a decrease in the real interest rate decreases the quantity of loanable funds supplied. An increase
in disposable income increases the supply of loanable funds; a decrease in disposable income decreases the
supply of loanable funds. An increase in wealth decreases the supply of loanable funds; a decrease in wealth
increases the supply of loanable funds. An increase in expected future income decreases the supply of
loanable funds; a decrease in expected future income increases the supply of loanable funds. Finally, an
increase in default risk decreases the supply of loanable funds; a decrease in default risk increases the supply
of loanable funds.

7.

How do changes in the demand for and supply of loanable funds change the real interest rate
and quantity of loanable funds?
The real interest rate is determined by the supply of loanable funds and the demand for loanable funds.
The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds supplied
equals the quantity of loanable funds demanded. Changes in the demand for or supply of loanable funds
change the equilibrium real interest rate and equilibrium quantity of loanable funds. If the demand for
loanable funds increases (decreases), the real interest rate rises (falls) and the quantity of loanable funds
increases (decreases). If the supply of loanable funds increases (decreases) the real interest rate falls (rises)
and the quantity of loanable funds increases (decreases).

Page 556
1.

How does a government budget surplus or deficit influence the market for loanable funds?
A government budget surplus adds to the supply of loanable funds. A government budget deficit adds to
the demand for loanable funds.

2.

What is the crowding-out effect and how does it work?


The crowding out effect refers to the decrease in investment that occurs when the government budget
deficit increases. An increase in the government budget deficit increases the demand for loanable funds. As
a result the real interest rate rises. The rise in the real interest rate decreasescrowds outinvestment.

3.

What is the Ricardo-Barro effect and how does it modify the crowding-out effect?
The Ricardo-Barro effect points out that the crowding out effect is less than predicted by looking only at
the effect of a budget deficit on the demand for loanable funds. The Ricardo-Barro effect asserts that as a
result of a government budget deficit households increase their saving to pay the higher taxes that will be

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needed in the future to repay the debt issued to fund the deficit. The increase in saving increases the supply
of loanable funds. This increase in the supply of loanable funds offsets the rise in the real interest rate from
the increase in the demand for loanable funds caused by the budget deficit. Because the real interest rate
does not rise as much, the decrease in investment, that is the amount of crowding out, is less in the
presence of the Ricardo-Barro effect.

Page 559
1.

Why do loanable funds flow among countries?


Loanable funds flow among countries because savers are searching for the highest (risk-adjusted) real
interest rate and borrowers are searching for the lowest (risk-adjusted) real interest rate.

2.

What determines the demand for and supply of loanable funds in an individual economy?
The demand for and supply of loanable funds in an economy with international lending and borrowing
depend on the same factors as in an economy without international lending and borrowing with one
exception: If, at the world real interest rate, the country has a surplus of funds, it can lend the surplus to
the rest of the world while if, at the world real interest rate, the country has a shortage of funds, it can
borrow from the rest of the world.

3.

What happens if a country has a shortage of loanable funds at the world real interest rate?
If a country has a shortage of loanable funds at the world real interest rate, it borrows from other nations
and becomes an international borrower.

4.

What happens if a country has a surplus of loanable funds at the world interest rate?
If a country has a surplus of loanable funds at the world real interest rate, it loans to other nations and
becomes an international lender.

5.

How is a government budget deficit financed in an open economy?


A government budget deficit increases the demand for loanable funds. In an open economy, the increase in
the demand for loanable funds means the country lends less to the rest of the world (if it initially was an
international lender) or borrows more from the rest of the world (if it initially was an international
borrower). These changes in lending or borrowing finance the budget deficit.

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Answers to the Problems and Applications


1.

Michael is an Internet service provider. On December 31, 2007, 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.
a. What was Michaels gross investment, depreciation, and net investment during 2008?
Michaels gross investment was $500,000, his depreciation was $100,000, and his net investment was
$400,000.

b. What is the value of Michaels capital at the end of 2008?


Michaels capital at the end of 2008 is equal to his capital at the beginning of 2008, $400,000, plus his net
investment during the year, also $400,000, for a total of $800,000.

2.

Lori is a student who teaches golf on the weekend and in a year earns $20,000 after paying her
taxes. At the beginning of 2007, Lori owned $1,000 worth of books, CDs, and golf clubs and
she had $5,000 in a savings account at the bank. During 2007, the interest on her savings
account was $300 and she spent a total of $15,300 on consumption goods and services. There
was no change in the market values of her books, CDs, and golf clubs.
a. How much did Lori save in 2007?
Loris saving equals her disposable income minus her consumption expenditure. Loris disposable income is
$20,000 plus the interest on her savings account, $300, for a total of $20,300.Her consumption
expenditure is $15,300, so her saving is $5,000.

b. What was her wealth at the end of 2007?


Loris wealth at the end of 2007 is equal to the value of her wealth at the beginning of 2007 plus her
saving during the year. At the beginning of 2007 Loris wealth is $6,000the value of her books, CDs,
golf clubs, and savings account. Lori saved $5,000 during 2007 so her wealth at the end of 2007 is
$11,000.

3.

First Call, Inc. is a cellular phone company. It plans to build an assembly plant that costs $10
million if the real interest rate is 6 percent a year. If the real interest rate is 5 percent a year,
First Call will build a larger plant that costs $12 million. And if the real interest rate is 7
percent a year, First Call will build a smaller plant that costs $8 million.
a. Draw a graph of First Calls demand for loanable funds
curve.
Figure 23.1 shows First Calls demand for loanable funds
curve.

b. First Call expects its profit from the sale of cellular


phones to double next year. If other things remain the
same, explain how this increase in expected profit
influences First Calls demand for loanable funds.
When First Call expects its profit to increase, First Call
increases its investment. The increase in its investment leads
First Call to increase its demand for loanable funds.

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FINANCE, SAVING, AND INVESTMENT

4.

363

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 23.2 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).

5.

The table shows an economys demand for


loanable funds and the supply of loanable funds
schedules, when the governments
budget is balanced.
Real interest
a. If the government has a budget
rate
surplus of $1 trillion, what are the
(percent per year)
real interest rate, the quantity of
4
investment, and the quantity of
5
private saving? Is there any
6
crowding out in this situation?
7
The real interest rate is 6 percent, the
8
quantity of investment is $7.5 trillion,
9
and the quantity of private saving is
10
$6.5 trillion. There is no crowding out.

Loanable
Loanable funds
funds
supplied
demanded
(trillions of 2002 dollars)
8.5
5.5
8.0
6.0
7.5
6.5
7.0
7.0
6.5
7.5
6.0
8.0
5.5
8.5

b. If the government has a budget deficit of $1 trillion, what are the real interest rate, the
quantity of investment, and the quantity of private saving? Is there any crowding out in this
situation?
The equilibrium real interest rate becomes 8 percent a year, the quantity of investment is $6.5 trillion, and
the quantity of private saving is $7.5 trillion. There is crowding out of $500 billion of investment.

c. If the government has a budget deficit of $1 trillion and the Ricardo-Barro effect occurs,
what are the real interest rate and the quantity of investment?
The equilibrium real interest rate remains 7 percent and the quantity of investment remains $7.0 trillion.
There is no crowding out because the $1 trillion increase in the budget deficit leads to an offsetting $1
trillion increase in private saving.

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6.

CHAPTER 23

In the loanable funds market in problem 5, the quantity of loanable funds demanded increases
by $1 trillion at each real interest rate and the quantity of loanable funds supplied increases by
$2 trillion at each interest rate.
a. If the government budget is balanced, what are the real interest rate, the quantity of loanable
funds, investment, and private saving? Does any crowding out occur?
The table shows the demand for
loanable funds and supply of loanable
funs schedules. The new real interest
rate is 6 percent, and the quantity of
loanable funds, private saving, and
investment are all $8.5 trillion. There is
no crowding out.

b. If the government budget becomes a


deficit of $1 trillion, what are the
real interest rate, the quantity of
loanable funds, investment, and
private saving? Does any crowding
out occur?

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

Loanable
Loanable funds
funds
supplied
demanded
(trillions of 2002 dollars)
9.5
7.5
9.0
8.0
8.5
8.5
8.0
9.0
7.5
9.5
7.0
10.0
6.5
10.5

The equilibrium real interest rate becomes 7 percent. The equilibrium quantity of loanable funds is $9.0
trillion, the equilibrium quantity of investment is $8.0 trillion, and the equilibrium quantity of private
saving is $9.0 trillion. There is crowding out of $500 billion of investment.

c. If governments want to stimulate the quantity of investment and increase it to $9 trillion,


what must they do?
Assuming no Ricardo-Barro effect, the government needs to have a budget surplus of $1 trillion. In this
case, the new equilibrium is at a real interest rate of 5 percent. The quantity of investment is $9 trillion
and the quantity of private saving is $8 trillion.

7.

Household Debt Now Rising Faster than Wealth


The debt of Canadian households is now rising faster than their wealth in the wake of the
stock market correction and a housing market slowdown. ... The mortgage market is still
expanding ... although it will likely slow by more than half ... due to the correction in the
formerly overheated markets in western Canadian cities and the tightening up of federal
mortgage lending restrictions. There are also early signs that the pace of growth in nonmortgage consumer credit is slowing. ... And thats a good thing, said CIBC economist and
author of the report Benjamin Tal. If household credit were to continue to rise by 13% a year
at some point I would become concerned because you would have too much credit and not
enough wealth to support it ... During the first quarter of the year, overall household debt
rose by almost 3%, while personal disposable income rose by 2%. ...].
Financial Post Magazine, August 19, 2008
a. Explain why the growth of household wealth has slowed in Canada.
Wealth is the value of all the things that people own. When people own shares and the value of the stock
market decreases, the growth of household wealth decreases. Similarly, when people own houses and the
value of houses decreases, the growth of household wealth decreases.
The growth of household wealth has also slowed in Canada because of the increase in household debt. To
find a household's wealth, we look at the difference between what the household owns and what it owes.
When debt increases, wealth decreases.

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b. When a household buys shares (stocks), does that represent consumption, saving, or
investment? Explain.
Saving is the amount of income that is not paid in taxes or spent on consumption goods and services.
Shares are not consumable; the purchase of shares are part of household saving.

c. When a household buys a new house, does that represent consumption, saving, or
investment? Explain.
Consumption is the purchase of goods and services such as orange juice, pizza, microwave ovens, and
haircuts. Saving is the amount of income that is not paid in taxes or spent on consumption goods and
services. Investment is the purchase of new plant, equipment, and buildings, and additions to inventories.
The purchase of a new house is investment.

d. What factors may influence a household when deciding between buying shares (stocks),
bonds, or a house?
When a household is deciding between buying shares, bonds, or a house, it considers the purpose for
which it is making the purchase.
In addition, it considers the ease with which it can borrow the money to make the purchase, the risk it
takes by making the purchase, and the expected wealth that results from the purchase.

8.

The Global Saving Glut and the U.S. Current Account, remarks by Fed Chairman Ben
Bernanke (when a governor of the Federal Reserve) on March 10, 2005:
On most dimensions 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 well
controlled. However, one aspect of U.S. economic performance still evokes concern among
economists and policymakers: 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. Bernanke went on to ask the following questions. What are
your answers to his questions:
a. 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.

b. What implications do the U.S. current account deficit (negative net exports) and our
consequent 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 its loans from the rest of the world and this repayment will detract from U.S. citizens well-being.

c. What policies, if any, should be used to address this situation?


If the goal is to decrease 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.

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9.

CHAPTER 23

The New New World Order


... While gross domestic product growth is cooling a bit in emerging markets, the results are
still tremendous compared with the United States and much of Western Europe. The 54
developing markets surveyed by Global Insight will post a 6.7% jump in real GDP this year,
down from 7.5% last year. The 31 developed countries will grow an estimated 1.6%. The
difference in growth rates represents the largest spread between developed and developing
markets in the 37-year history of the survey.
Fortune, July 14, 2008
a. Do growth rates of real GDP over the past few decades indicate that world saving is
shrinking, growing, or staying the same? Explain.
It is likely that world saving is growing. As disposable income grows, saving grows since higher disposable
income increases saving.

b. If the world demand for loanable funds remains the same, will the world real interest rate
rise, fall, or remain the same? Explain.
If the world demand for loanable funds remains the same, the growing supply of loanable funds leads to a
falling real interest rate.

10.

IMF Warning Over Slowing Growth


The global economy may face a marked slowdown next year as a result of the turmoil in
financial markets, the International Monetary Fund has warned. The IMF said the global
credit squeeze would test the ability of the economy to continue expanding at recent rates.
While future economic stability could not be taken for granted, there was plenty of evidence
that the global economy remained durable, it added.
BBC News, October 10, 2007
a. Explain how turmoil in global financial markets might affect the demand for loanable funds,
investment, and global economic growth in the future.
The turmoil in financial markets leads some people to decrease their saving because of fear that they might
lose these funds due to the turmoil; in other words, default risk increases. As a result, the supply of
loanable funds decreases, which pushes up the real interest rate. The primary source demanding loanable
funds is business firms who want these funds to make investment. If the real interest rate rises, the quantity
of loanable funds demanded decreases as businesses cancel no-longer profitable investments. With less
investment there will be less capital and so the growth in potential GDP slows.

b. What might be the evidence that the global economy will continue to grow?
Growth will remain if investment continues to be robust. Investment depends on the real interest rate and
expected profit. At the time of the report, there seemed to be little sign that the global credit squeeze was
resulting in a sharply higher real interest rate, which would serve to decrease investment. The historical
evidence is that the demand for and supply of loanable funds increase at about the same rate, so there is no
upward trend in the real interest rate. Additionally the IMFs report does not explicitly mention a higher
real interest rate. It also is likely that profit expectations have not plummeted. Survey data could be used to
try to get a read on profit expectations. But perhaps more objectively, real GDP continued to expand at a
reasonably fast clip in many countries and this relatively rapid expansion probably increased future profit
opportunities.

11.

Annie runs a fitness centre. On December 31, 2008, she bought an existing business with
exercise equipment and a building worth $300,000. During 2009, business improved and she
bought some new equipment for $50,000. At the end of 2009, her equipment and buildings
were worth $325,000. Calculate Annies gross investment, depreciation, and net investment

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during 2009.
Annies net investment during 2009 is $25,000 because that is the change in her capital stock. Annies
gross investment is $50,000 because that is her total purchase of capital equipment in 2009. Annies
depreciation during 2009 is $25,000 because Annies net investment, $25,000, equals her gross
investment, $50,000, minus her depreciation.

12.

Karrie is a golf pro, and after she paid taxes, her income from golf and interest from financial
assets was $1,500,000 in 2008. At the beginning of 2008, she owned $900,000 worth of
financial assets. At the end of 2008, Karries financial assets were worth $1,900,000.
a. How much did Karrie save during 2008?
Karries wealth increased by $1,000,000 in 2008. So her saving in 2008 is $1,000,000. (This point
assumes no capital gains or losses on her stocks and bonds.)

b. How much did she spend on consumption goods and services?


Her income after taxes was $1,500,000. Her consumption equals her income minus her saving, which is
$1,500,000 $1,000,000 = $500,000.

13.

In 2008, the Lee family had a disposable income of $80,000, wealth of $140,000, and an
expected future income of $80,000 a year. At a real interest rate of 4 percent a year, the Lee
family saves $15,000 a year; at a real interest rate of 6 percent a year, they save $20,000 a year;
and at a real interest rate of 8 percent, they save $25,000 a year.
a. Draw a graph of the Lee familys supply of
loanable funds curve.
Figure 23.3 shows the Lee familys supply of loanable
funds curve.

b. In 2009, suppose that the stock market crashes


and the default risk increases. Explain how this
increase in default risk influences the Lee
familys supply of loanable funds curve.
If default risk increases the Lee family will decrease its
saving. As a result, the Lee familys supply of loanable
funds decreases and its supply of loanable funds curve
shifts leftward.

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CHAPTER 23

14.

Draw a graph to illustrate the effect of an increase


in the demand for loanable funds and an even
larger increase in the supply of loanable funds on
the real interest rate and the equilibrium quantity
of loanable funds.
Figure 23.4 shows the effect of an increase in the
demand for loanable funds and an even larger increase
in the supply of loanable funds. The demand curve
shifts rightward from DLF0 to DLF1, and the supply
curve shifts rightward from SLF0 to SLF1. The increase
in supply is larger than the increase in demand, so the
real interest rate falls (from 6 percent to 5 percent in
the figure) and the quantity of loanable funds increases
(from $2.3 trillion to $2.7 trillion in the figure).

15.

Indias Economy Hits the Wall


Just six months ago, India was looking good.
Annual growth was 9%, corporate profits were
surging 20%, the stock market had risen 50% in 2007, consumer demand was huge, local
companies were making ambitious international acquisitions, and foreign investment was
growing. Nothing, it seemed, could stop the forward march of this Asian nation. But stop it
has. ... The country is reeling from 11.4% inflation, large government deficits, and rising
interest rates. Most economic forecasts expect growth to slow to 7%a big drop for a
country that needs to accelerate growth, not reduce it. A June 16 report by Goldman Sachs
Jim ONeill and Tushar Poddar urges India to improve governance, raise educational
achievement, and control inflation. It also advises liberalizing its financial markets.
BusinessWeek, July 1, 2008
a. Suppose that the Indian government reduces its deficit and gets back to a balanced budget. If
other things remain the same, how will the demand or supply of loanable funds in India
change?
If the Indian government reduces its deficit, the demand for loanable funds decreases.

b. With economic growth forecasted to slow, future incomes are expected to fall. If other things
remain the same, how will the demand or supply of loanable funds in India change?
If expected future incomes slow, the major effect is an increase in the supply of loanable funds as
households increase their saving.

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16.

369

The Global Savings Glut and its Consequences


The world is experiencing an unprecedented glut of savings, driving down real interest rates. It
is a good time to borrow rather than lend. Several developing countries are running large
current account surpluses (representing an excess of savings over investment). China has
the biggest surplus of $1.2 trillion, but other developing countries put together have
accumulated almost as much. Rapid growth leads to high saving rates: people save a large
fraction of additional income. In India, GDP growth has accelerated from 6% to 9%, lifting
the saving rate from 23% a decade ago to 33% today. Chinas saving rate is a dizzy 55%. Not
even the investment boom in Asia can absorb these huge savings, which are therefore put into
U.S. bonds. When a poor country buys U.S. bonds, it is in effect lending to the United States.
Cato Institute, June 8, 2007
a. Graphically illustrate and explain the impact of the unprecedented glut of savings on the
real interest rate and the quantity of loanable
funds.
Figure 23.5 shows the global loanable funds market. In
the world market for loanable funds the supply of
loanable fundsthe so-called glut of savingshas
significantly increased the supply of loanable funds.
The supply curve shifts rightward from SLF0 without
the glut to SLF1 with it. The increase in the supply of
loanable funds lowers the real interest rate, in the
figure from 6 percent to 4 percent, and increases the
quantity of loanable funds, in the figure from $23
trillion to $25 trillion.

b. How do the high saving rates in China and India


impact investment in the United States? How
does this investment influence the production
function and potential GDP in the United
States?
The highs savings rates impact the United States by lowering the real interest rate in the United States.
U.S. investment increases (as does U.S. borrowing from abroad). The increase in investment boosts the
U.S. capital stock. As a result, the U.S. aggregate production function shifts upward and U.S. potential
GDP increases.

17.

Chinas Integration Into the Global Financial System

Chinas global economic significance is growing. Its gross domestic product (GDP) is the
worlds second largest when measured in terms of purchasing-power parities, and its share in
world exports is exceeded only by Germanys and that of the United States. China is Canadas
second largest trading partner, and trade between the two countries is continuing to grow
rapidly. ... Yet China has only a minor role in the global financial system. Its banks, some of
which are the largest in the world by market capitalization and the size of their balance sheets,
have only a modest international presence. ... Chinas currency ... is virtually not used outside
the country and, with a few exceptions, Chinese capital markets are not a source of financing
for foreign borrowers. Chinas lack of integration into the global financial system needs to be
understood primarily in the context of Chinas own interests and domestic policy priorities.
The central economic goal of the Chinese authorities has been to achieve growth with stability

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CHAPTER 23

while radically restructuring the industrial sector and creating enough jobs each year to absorb
layoffs and large numbers of new entrants into the labour force. ... As the Chinese economy
matures, however, and as reforms strengthen the domestic financial system, China will become
more important in global financial markets. Changes are already occurring as Chinas
financial might is being channeled towards overseas investments. ...
Bank of Canada Review, Summer 2008
a. Explain the effects of increased integration of
China into the global loanable funds market.
Will the world equilibrium real interest rate
rise or fall as China becomes more integrated?
Draw a graph to illustrate your answer.
As a result of the increased integration of China into
the global loanable funds market, the supply of
loanable funds increases. The supply of loanable
funds curve shifts rightward. The real interest rate
will fall. Figure 23.6 illustrates.

b. Explain the potential effect on Canada of an


increased Chinese presence in global financial
markets.
The world real interest rate will be lower than what it
is with China in isolation. Since 2000, Canada has
been a net lender. The lower real interest rate will
lead to an increase in Canadian investment.

c. What are the advantages and disadvantages to China


of isolating itself from the global loanable funds
market?
Figure 23.7 shows the market for loanable funds in China
and the world real interest rate, assumed to be 4 percent a
year. In the figure, if there was no international lending and
borrowing the real interest rate China would be 3 percent a
year, the interest rate that sets the quantity of loanable funds
demanded in China equal to the quantity supplied. If China
did not isolate itself from the world, it could increase its
lending abroad and increase net exports.

Copyright 2010 Pearson Education Canada

FINANCE, SAVING, AND INVESTMENT

18.

371

Greenspans Conundrum Spells Confusion for Us All


At the beginning of the year, the consensus was that bond yields would rise ... Gradually,
over February, the consensus has started to reassert itself. Ten-year Treasury bond yields
were hovering below 4 percent in the early part of the month but now they are around 4.3
percent. Because the consensus was that bond yields should be 5 percent by the end of the
year, most commentators have focused, not on why bond yields have suddenly risen, but on
why they were so low before. A number of explanations for this conundrum have been
advanced. First, bond yields are being held artificially low by unusual buying. . Another
[is]... bond yields reflect investors expectations for an economic slowdown in 2005.
Financial Times, February 26, 2005
a. Explain how unusual buying might lead to a low real interest rate.
Unusual buying means that the demand in the financial market for bonds is unusually large. In this
case, the unusually large demand leads to bond prices being unusually high. Higher bond prices mean a
lower interest rate on the asset. So unusually high bond prices creates unusually low interest rates on
bonds.

b. Explain how investors expectations for an economic slowdown might lead to a lower real
interest rate.
Investors expectations of an economic slowdown mean that the expected profit from investing in capital
falls. The lower expected profit decreases the demand for investment, which decreases the demand for
loanable funds. The fall in the demand for loanable funds then lowers the equilibrium real interest rate.

19.

Study Reading Between the Lines on pp. 560561 and then answer the following questions.
a. What was the financial rescue package proposed by the Administration and what was it
supposed to do?
The financial package enabled the U.S. government to buy the risky assets (the toxic assets) currently
owned by financial institutions. These purchases decreased the risk that financial institutions would
become insolvent. The result of this action was hoped to be a general decrease in default risk and a
restoration of the normal functioning of the loanable funds market.

b. What did the U.S. Congress hope would occur after the rescue package was passed?
The U.S. Congress hoped that the loanable funds market would start to function normally, with loans
being made more freely. Longer term, the U.S. Congress hoped that the supply of loanable funds and the
demand loanable funds would both increase, helping the economy exit the recession more rapidly.

c. Based on what happened in the stock market, do you think we can conclude that suppliers of
loanable funds believed that the rescue package was needed and would work? Explain your
answer.
The stock market fell drastically after the package failed. This fall suggests that suppliers of loanable funds
believed the package was necessary and would work. Without the package the supply of loanable funds
drastically decreased, driving down the prices of equities and thereby driving up the real interest rate paid
on these assets. The stock market gained slightly after the economic bailout package passed in U.S.
Congress. This fact suggests that people were more willing to invest in the stock market because the
package decreased the default risk so the supply of loanable funds increased.

d. What did people fear would occur if the rescue package was not passed?
People feared that both the demand for and supply of loanable funds would decrease, thereby decreasing
the equilibrium quantity of loanable funds. Then the decrease in loanable funds, together with the poorly
functioning financial market, would drive the economy further into a recession.

Copyright 2010 Pearson Education Canada

372

CHAPTER 23

e. Based on what happened in the stock market, do you think we can conclude that suppliers of
loanable funds shared the governments fears? Explain your answer.
The stock market fell drastically after the rescue package failed to pass in U.S. Congress. Based on this
result, the suppliers of loanable funds seem to have shared the same fear as the people. In the time
immediately after the package initially failed, the supply of loanable funds decreased, driving down the
price of equities, and driving up the real interest rate. In the longer term, apparently the suppliers of
loanable funds feared that with the economy in a recession, the risk of default would drastically rise,
thereby decreasing the supply of loanable funds.

f.

What other measures might the government take if it wants to boost supply and demand in
the market for loanable funds?
The two major issues that affect the loanable funds market are the (vastly) increased default risk and the
worry that the U.S. economy will slide into recession, which lowers expected profit. The first factor
decreases the supply of loanable funds (and makes lending itself more risky) and the second factor
decreases the demand for loanable funds. The government might try to combat the first factor by insuring
the return on the risky assets. The government can try to combat the second factor by taking actions to
help combat a recession.

g. How do you think the global nature of the loanable funds markets influences how the U.S.
market would have responded to no rescue?
If there was no rescue, the global nature of the loanable fund market helps limit the change in the real
interest rate that might occur. For example, if the real interest rate in the United States had risen
substantially with no rescue plan, the global nature of the loanable funds market would have limited the
rise that would have occurred.

Copyright 2010 Pearson Education Canada