Keynesian Income Expenditure Model 2

• The Keynesian Income and Expenditure Model II helps understand the relationship between savings and investment spending.
• It describes how the loanable funds market matches savers with borrowers.

Savings and Investment Spending

• Increases in the economy’s levels of human capital (H) and physical capital (K) are essential for economic growth.
• Governments usually provide human capital through public education.
• In countries like the US with large private sectors, post-secondary education is a significant source of human capital (H).
• Private investment spending (I) mainly creates physical capital (K), excluding infrastructure, and spending by firms rather than the government.
• Individuals and firms often use other people’s money to create physical capital (K) in the modern economy.
• The savings-investment spending identity is an accounting fact meaning savings and investment spending are always equal for the economy as a whole.

Savings-Investment Spending Identity in a Closed Economy

• Gross Domestic Product (GDP) or (Y) represents the total spending on final goods and services produced domestically.
• Formula for GDP is: Y = C + I + G + (X – IM), where:
  • C is consumption.
  • I is investment.
  • G is government spending.
  • X is exports.
  • IM is imports.
• Consumptions of goods and services (C and G) or savings (S) represents how income can be spent
• Y = C + G + S
• In a closed economy, exports (X) and imports (IM) are zero.
• Therefore: C + I + G = C + G + S, leading to I = S

Savings

• Savings are examined more closely
• Households save when income exceeds consumption and taxes (T).
• The government saves when its tax revenue (T) exceeds its spending (G) and transfer payments (TR), resulting in a positive budget balance.
• Budget balance is calculated as: T - G - TR.
• A budget surplus occurs when T > G - TR.
• A budget deficit occurs when T < G - TR.
• National savings equals:
  • SNational = SGovernment + Sprivate
  • SNational = (T - G - TR) + Sprivate
• In a closed economy, savings equal national savings (S = SNational.
• The savings-investment spending identity is SNational = I.
• A budget deficit occurs when G + TR > T
• Government "dissaves" with a budget deficit.
• Governments borrow to finance budget deficits.
• Government borrowing is funds borrowed by federal, state, and local governments in the financial markets.

Savings-Investment Spending Identity in an Open Economy

• Goods and money flow into and out of an open economy.
• Foreign savings can finance investment spending when a country receives inflows of funds.
• Domestic savings can finance investment spending in another country when a country generates outflows of funds.
• The savings-investment spending identity changes because savings do not need to be spent on investment in the same country where the savings are generated.
• Net capital flow is the total flow of funds into a country minus the total flow of funds out of a country.
• A positive net capital flow indicates extra funds from abroad for investment spending (I).
• A country must borrow the difference from foreigners if it spends more on imports (IM) than it earns from exports (X).
• The amount borrowed is the net capital inflow (NCI).
• Formula for net capital inflow: NCI = IM - X, where a net capital outflow (NCO) occurs when IM < X.
• Rearranging the equation: I = (Y – C – G) + (IM – X).
• Investment (I) equals national saving plus net capital inflow: I = SNational + NCI.
• In 2021, the savings-investment spending identity was reflected differently in the world’s major economies
• The US's investment was financed by private savings and net capital inflow, partially offset by a government budget deficit.
• Germany's investment was financed by private savings and offset by net capital outflow and government deficit.

Market for Loanable Funds

• For the economy as a whole, savings (S) equals investment (I).
• In a closed economy: Savings (S) = National Savings (SNational ).
• Therefore: (SNational ) = Investment (I)
• In an open economy: Savings (S) = National Savings + Net Capital Inflow. (SNational + NCI).
• Therefore: (SNational + NCI) = Investment (I)
• Savers and borrowers connect through financial markets, channeling household savings to businesses for capital equipment purchases (I).
• The loanable funds market brings savers and borrowers together.
• The loanable funds market illustrates the market outcome
  • Demand for funds is generated by borrowers
  • Supply of funds is provided by lenders
• The interest rate is the price of loans.

Demand for Loanable Funds

• The demand curve for loanable funds slopes downward, showing more demand at lower interest rates.
• The x-axis measures the quantity of loanable funds demanded.
• The y-axis measures the interest rate, which represents the "price" of borrowing.
• The demand curve slopes downward, showing that firms want to undertake more projects when interest rates are lower.

Investments

• An investment is worth making only if the future return exceeds the monetary cost of the investment today.
• Compare today’s cost of investment with a future return
• Present value refers to the amount of money needed today to receive a given amount in the future, considering the interest rate.
• The future value of X in n years is FV = PV (1 + r)^n
• The present value can also be expressed as PV = FV / (1 + r)^n

Supply of Loanable Funds

• The supply of loanable funds curve slopes upward
• Loanable funds are supplied by savers.
• By saving money today and earning interest, savers are rewarded with higher consumption in the future.
• Higher interest rates encourage more people to forgo current consumption and lend to borrowers, resulting in the supply curve sloping upward.

Equilibrium Interest Rate

• The equilibrium interest rate (r*)
• It is the quantity of lending (Q*) are determined by the intersection of the supply and demand for loanable funds (LF).
• r* is the interest rate at which the quantity of loanable funds supplied (QLFs) equals the quantity of loanable funds demanded (QLFd)
• The loanable funds market efficiently matches desired savings with desired investment spending.

Demand Shifts

• The demand for loanable funds can shift due to:
  • Changes in beliefs regarding business opportunities
  • Government borrowing when they run budget deficits
• D↑ leads to r↑
• Increasing or persistent government budget deficits are a cause for concern.
• Rising interest rates can cause businesses to cut back on their investment (I).
• Crowding out occurs when a government budget deficit increases the interest rate, leading to reduced investment spending.
• Crowding out may not occur if in an depressed economy:
  • Government spending leads to Higher incomes
  • Which in turn leads to Increased savings
  • Resulting in the Government being able to borrow without raising interest rates

Supply Shifts

• The supply of loanable funds can shift due to:
  • Changes in private savings behavior
  • Changes in net capital inflows caused by investor perceptions of a country.

Inflation and Interest Rate

• Any shift in either the supply or demand for loanable funds changes the interest rate
• Several factors drive major changes in interest rates, including:
  • Government policy changes
  • Technological innovations creating new investment opportunities
  • People’s expectations about future inflation
• The effect of inflation on borrowers and lenders is (r = i – π)
  • Where (r) is the real interest rate
  • Where (i) is the nominal interest rate
  • Where (π) is inflation
• The real cost of borrowing is r, not i.
• In an example, a firm borrows $10,000 for one year at a 10% nominal interest rate (i).
• At the end of the year, it must repay $11,000, the principal plus the interest.
• Suppose that over the year, the average level of prices increases by 10%, so the real interest rate is 0 (r = i − π = 10% - 10% = 0).
• Then the $11,000 repayment has the same purchasing power as the original $10,000 loan, meaning the borrower has received a zero-interest loan.
• Another example: You lend someone $10,000 at an interest rate of 10%.
• After one year, you receive $11,000, gaining $1,000 in interest.
• Suppose that over the course of the year, the average level of prices increases by 10%, so that the real interest rate is 0 (r = i − π = 10% - 10% = 0)
• The $11,000 you received has the same purchasing power as the original $10,000 you lent out a year ago, meaning you (the lender) did not gain anything.
• The true cost of borrowing and payoff of lending is the real interest rate (r).
• Loan contracts specify a nominal interest rate (i).
• Neither the bank nor the borrower knows what inflation will be until we look back at the end of the year

Fisher Effect

• The expectations of borrowers and lenders about future inflation rates are normally based on recent experience.
• An increase in expected future inflation drives up (i), leaving the (r) unchanged based on the Fisher effect.
• Both lenders and borrowers base their decisions on the expected real interest rate.
• A change in the expected rate of inflation does not affect the equilibrium quantity of loanable funds or the expected real interest rate; all it affects is the equilibrium nominal interest rate.
• In a scenario:
  • The expected real interest rate is unaffected by changes in expected future inflation. r^e = i - π^e = 4% - 0% = 4%
  • Now we suppose that π^e rises to 10%. The demand shifts upward
  • Borrowers now want to borrow as much at a nominal interest rate of 14% as they were previously willing to borrow at 4%.
  • Because with π^e = 10%, i = 14%, It will continue to yield an (r = 4%), lenders need to require (i = 14%) to persuade them to lend as much as they would previously have lent at (i = 4%)
• The new equilibrium is at E10, which is the result of an expected future inflation rate of 10% and equilibrium nominal interest rate rises from 4% to 14%.