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Macroeconomics ECO 403

LESSON 09

NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES

(Continued...)

Government spending, G

G includes government spending on goods and services.

G excludes transfer payments

Assume government spending and total taxes are exogenous:

The market for goods & services

Summarizing the Discussion so far:

Y=C+I+G

C = C(Y - T)

I = I(r)

G=G

T=T

Market for goods & services

Agg. Demand:

C(Y - T) + I(r) + G

Agg. Supply:

Y = F(K, L)

Equilibrium:

Y = C(Y - T) + I (r) + G

The real interest rate adjusts

to equate demand with supply.

The loanable funds market

A simple supply-demand model of the financial system.

One asset:

"loanable funds"

demand for funds: investment

supply of funds: saving

"price" of funds:

real interest rate

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Macroeconomics ECO 403

Demand for funds: Investment

The demand for loanable funds:

Comes from investment:

Firms borrow to finance spending on plant & equipment, new office buildings, etc.

Consumers borrow to buy new houses.

· Depends negatively on r , the "price" of loanable funds (the cost of borrowing).

Loanable funds demand curve

The investment curve is also the

demand curve for loanable funds.

I (r)

Supply of funds: Saving

The supply of loanable funds comes from saving:

Households use their saving to make bank deposits, purchase bonds and other assets.

These funds become available to firms to borrow to finance investment spending.

The government may also contribute to saving if it does not spend all of the tax

revenue it receives.

Types of saving

Private saving = (Y T) C

Public saving =

National saving, S

= private saving + public saving

= (Y T) C + T G

Y C G

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Macroeconomics ECO 403

Digression:

Budget surpluses and deficits

When T > G, budget surplus = (T G) = public saving

When T < G, budget deficit = (G T) and public saving is negative.

When T = G, budget is balanced and public saving = 0.

Budget Deficit of Pakistan

(as % of GDP)

1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02

Loanable funds supply curve

S = Y C(Y - T) - G

National saving does

not depend on r,

so the supply curve is

vertical.

S, I

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Macroeconomics ECO 403

Loanable funds market equilibrium

S = Y C(Y - T) - G

Equilibrium real

interest rate

I (r )

S, I

Equilibrium level of

investment

The special role of r

r adjusts to equilibrate the goods market and the loanable funds market simultaneously:

If L.F. market in equilibrium, then

S=I

(Y C G) = I

Rewriting as:

Y = C + I + G (goods market equilibrium)

Thus,

Equilibrium in Loanable funds Market

Equilibrium in goods Market

Digression: mastering models

To learn a model well, be sure to know:

1. Which of its variables are endogenous and which are exogenous.

2. For each curve in the diagram, know

definition

intuition for slope

all the things that can shift the curve

3. Use the model to analyze the effects of each item in 2c.

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Macroeconomics ECO 403

Mastering the loanable funds model

1. Things that shift the saving curve

· Public saving

· Fiscal policy: changes in G or T

· Private saving

· Preferences

· Tax laws that affect saving

Now you try...

Draw the diagram for the loanable funds model.

Suppose the tax laws are altered to provide more incentives for private saving.

What happens to the interest rate and investment?

(Assume that T doesn't change)