ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The Classical Model (II): The Loanable Funds Market

1. The Demand Side of the Classical Model In the classical view of output determination, the labor market reaches the full employment and therefore the economy produces its potential output automatically in the long run. How about the demand side? Is there enough expenditure to buy all the output produced? o If firms cannot sell all the output, the full employment and potential output level cannot sustain. Recall the circular flow diagram that depicts the operation of a very simple economy consisting of domestic households and domestic firms only. o Total Production (Output) = Total Income = Total Expenditure

Income Resource (Production Factors) Markets Labor, Capital, Land

Factor Payments

Households (Consumers)

Firms (Producers)

Goods and Services Goods Markets Expenditure Revenue

Says law: Supply creates its own demand o By producing goods and services, an equal amount of income is created. In a simple economy in which domestic households spend all of their income on domestic output, total expenditure must be equal to total output. o Caveat: The Says law shows the aggregate spending in economy will equal the aggregate output. It may not apply to individual level.

The Says law ensures the goods market is in equilibrium under the classical view.

2. The Goods Market Equilibrium (Closed Economy) To explore the goods market equilibrium in a more general sense (more realistic economy), we consider a closed economy and examine the demand for output (the planned expenditure).

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Recall that the actual expenditure (or GDP) can be defined as:
GDP C I G NX

Is it always equal to the planned expenditure, which is the total amount that the economy (including all households, businesses, government and foreigner) would like to spend? Why? o Firms may engage in unplanned inventory investment (or unplanned change in inventory) when their sales do not meet their expectations. For simplicity, we assume all inventory investment to be unplanned and the firms planned investment expenditure includes only their planned spending on capital goods. On the other hand, C, G and NX are always intentional.

A closed economy refers to any economy that does not deal with the rest of the world, i.e. NX = 0. o Therefore, this model may also be applied as a model describing an economy with balanced trade, i.e. X = M (NX = 0). Therefore, a closed economy consists of: o Households who spend their income on consumption, saving and paying taxes. o Firms that spend on capital goods (investment expenditure) o Government that collects taxes and spend the taxes revenues on goods and services (government expenditure) The planned expenditure in the closed economy:
Ep C I p G

In a closed economy, the goods market is in equilibrium when the supply of output (i.e. potential GDP) equals the demand for output (planned expenditure):
Y C I p G

To explore what ensures that the goods market is in equilibrium, we rearrange the terms and adding an extra term T (net taxes):
Y C I p G

Y T C I p (G T ) S I p (G T )

o o o o

Net taxes (T) = Total tax revenue Total transfer payments Disposable income (Y T): The income that households that can use at their discretion. (Household) Saving (S) = Y T C Budget Deficit = G T (if > 0) Budget surplus: G T < 0 Balanced budget: G T = 0

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Therefore, the goods market equilibrium condition can be rewritten as:

S T I p G

o o

The left hand side (S + T) is called the leakages out of households spending households income received but unspent. The right hand side (Ip + G) is called the injections spending from sources other than households.

The goods market will be in equilibrium if and only if total leakages are equal to total injections. o This condition ensures that Says law holds in the more realistic closed economy. o But what is the mechanism that ensures leakages = injections?

3. The Loanable Funds Market To understand the equality of leakages and injections, it requires the study of loanable funds market, i.e. the market in which savers make their funds available to borrowers. Recall that the goods market equilibrium condition can be written as:
S I p (G T )

o o

The left hand side of the equation is the household saving, which is also the supply of loanable funds. The right hand side of the equation is the firms planned investment expenditure and government budget deficit, which is also the demand for loanable funds.

4. The Supply of Loanable Funds (Saving) The households supply funds by putting their savings in banks (which will then lend the funds), investing in bonds (direct lending to firms or government) or investing in stocks (buying shares of ownership of firms) in order to earn interest. To understand the determinants of saving/consumption, we must realize saving/consumption decision involves a tradeoff between current consumption and future consumption. o Real interest rate (r): the relative price of current consumption in terms of future consumption forgone. Note: while there are many interest rates in real world, we ignore the fine details in macroeconomics and regard the interest rate as an average of all the different interest rate in real world. When interest rate increases, consumption spending will decrease and saving will increase.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Real interest rate (r) Supply of loanable funds, (Saving, S)

Loanable Funds

Other factors affecting saving/consumption: o Current Income (Y) Households desire to have a relatively even pattern of consumption over time (consumption smoothing), so when current income increases, households will spend part of the increased income and save part of it. Both the current consumption spending and saving will increase. o Expected future income When expected future income increases, households would increase both the future consumption and current consumption by reducing saving, given the current income unchanged. Consumption will increase and saving will decrease. Wealth (i.e. total value of households assets) When expected future income increases, households would increase both the future consumption and current consumption by reducing saving, given the current income unchanged. Consumption will increase and saving will decrease. Taxes affecting the returns to saving Capital gains tax: A tax on profits earned from financial investment. Consumption tax: A tax on the part of income that households spend.

5. The Demand for Loanable Funds (Planned investment & Budget Deficit) The firms demand funds to purchase capital goods (i.e. investment) and the government demands funds to finance their budget deficit by borrowing from the banks, selling bonds or shares. In return, they have to pay interest. To understand the firms demand for funds, we have to understand the firms investment decision (demand for capital), which is simply a marginal benefit and marginal cost analysis (analogous to that of the demand for labor):

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Expected rate of return Suppose a firm considers buying a capital good (machine) that costs $10,000 and has a useful life of one year (for simplicity). If this machine is expected to produce an additional output of 100 units per day and each unit of output can be sold at $11 (suppose other inputs remain fixed). What is the additional benefit of purchasing this additional capital good?
e The MRPK measures the marginal benefit of employing an additional capital in terms

of the extra revenue produced:

e e MRPK P MPK

e The expected MRPK is $11000. Suppose there is no other cost, the expected return to

this machine is $1000. In this case, the expected rate of return is therefore E(r) = $100/$1000 = 10%. o Real interest rate (r) Suppose the firm has to borrow money to finance its purchase, the cost of investment is the real interest rate. What if the firm is using its own funds to finance the purchase? Should the firm invest in the capital if real interest rate is 5%? A firm will invest in a capital good as long as expected rate of return r.

Investment demand curve shows the total amount of investment at each interest rate. o It is downward sloping because at a lower interest rate, more investment projects are profitable, other things constant. o It is also the demand for loanable funds from the firms.

Real interest rate (r)

Planned Investment (Ip) Investment (Ip)

Other factors affecting planned investment:

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Any factors affecting expected rate of return when expected rate of return increases, planned investment will increase. Expected marginal productivity of capital Technology Existing capital stocks Expected future business environment and profitability Taxes affecting the expected rate of return Corporate profit tax: A tax on profits earned by firms. Investment tax credit: A reduction in taxes for firms that invest in new capital.

o o

On the other hand, the government demand for funds simply to finance any budget deficit o Unlike firms, government borrowing is independent of the real interest rate.

Real interest rate (r)

Budget Deficit (G T)

Budget deficit

The total demand for loanable funds is the horizontal summation of the firms demand for loanable funds (investment demand curve) and the governments demand for loanable funds (budget deficit), which is downward sloping.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Real interest rate (r)

Demand for loanable funds, [Ip + (G T)] Loanable Funds

What of government runs a budget surplus, i.e. G T < 0? o The government surplus turns into a supply of loanable funds and is horizontally summed with the household saving to derive the total supply of loanable funds curve.

6. The Loanable Funds Market Equilibrium Based on the assumption of the classical economists, the loanable funds market clears i.e. the equality of demand and supply of loanable funds. o The real interest rate adjusts until the loanable market is in equilibrium. o What would happen if interest rate is too low? Too high?

Real interest rate (r) Supply of loanable funds, (Saving, S)

Demand for loanable funds, [Ip + (G T)] S = Ip + (G T) Loanable Funds

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Notice that when the loanable funds market clears, i.e. S = Ip + (G T), it implies:
S T I p G

That is, the goods market will also be in equilibrium as the total leakages are equal to total injections, which ensures Says law to hold in the more realistic closed economy.

7. Fiscal Policy (The classical view) Fiscal policy: a change in government spending or net taxes designed to affect total output. o What is the effect on budget deficit (G T)? An increase in government spending (a decrease in net taxes): o Higher interest rate, which results in: An increase in saving (a decrease in consumption) An decrease in planned investment o Crowding Out effect A decline in one sectors spending caused by an increase in some other sectors spending. In the classical model, a rise in government purchases completely crowds out private sector spending, so total spending remains unchanged.

Real interest rate (r) S

r2

r1 [Ip + (G2 T)] [Ip + (G1 T)] S1 = Ip1 + (G1 T) S2 = Ip2 + (G2 T) S1 = Ip1 + (G2 T) Loanable Funds

Readings: Chapter 20 (p.607 625): The Appendix is the classical model for the open economy and is excluded for now.

undertaking a progress, the late Deng Xiaoping set out on a southern tour of the most reform-minded provinces. An astonishing endorsement of reform, it was a masterstroke from the man who made modern China. The economy has barely looked back since. Compared with the rich worlds recent rocky times, Chinas progress has been relentless. Yet not far beneath the surface, society is churning. Recent village unrest in Wukan in Guangdong, one province that Deng toured all those years ago; ethnic strife this week in Tibetan areas of Sichuan; the gnawing fear of a house-price crash: all are signs of the centrifugal forces making the Communist Partys job so hard. The partys instinct, born out of all those years of success, is to tighten its grip. So dissidents such as Yu Jie, who alleges he was tortured by security agents and has just left China for America, are harassed. Yet that reflex will make the partys job harder. It needs instead to master the art of letting go. Chinas third revolution The argument goes back to Dengs insight that without economic growth, the Communist Party would be history, like its brethren in the Soviet Union and eastern Europe. His reforms replaced a failing political ideology with a new economic legitimacy. The partys cadres set about remaking China with an energy and single-mindedness that have made some Westerners get in touch with their inner authoritarian. The bureaucrats not only reformed Chinas monstrously inefficient state-owned enterprises, but also introduced some meritocracy to appointments. That mix of political control and market reform has yielded huge benefits. Chinas rise over the past two decades has been more impressive than any burst of economic development ever. Annual economic growth has averaged 10% a year and 440m Chinese have lifted themselves out of povertythe biggest reduction of poverty in history. Yet for Chinas rise to continue, the model cannot remain the same. Thats because China, and the world, are changing. China is weathering the global crisis well. But to sustain a high growth rate, the economy needs to shift away from investment and exports towards domestic consumption. That transition depends on a fairer division of the spoils of growth. At present, Chinas banks shovel workers savings into state-owned enterprises, depriving workers of

China

The paradox of prosperity

For Chinas rise to continue, the country needs to move away from the model that has served it so well
Jan 28th 2012 | from the print edition

IN THIS issue we launch a weekly section devoted to China. It is the first time since we began our detailed coverage of the United States in 1942 that we have singled out a country in this way. The principal reason is that China is now an economic superpower and is fast becoming a military force capable of unsettling America. But our interest in China lies also in its politics: it is governed by a system that is out of step with global norms. In ways that were never true of post-war Japan and may never be true of India, China will both fascinate and agitate the rest of the world for a long time to come. Only 20 years ago, China was a long way from being a global superpower. After the protests in Tiananmen Square led to a massacre in 1989, its economic reforms were under threat from conservatives and it faced international isolation. Then in early 1992, like an emperor

spending power and private companies of capital. As a result, just when some of the other ingredients of Chinas boom, such as cheap land and labour, are becoming scarcer, the government is wasting capital on a vast scale. Freeing up the financial system would give consumers more spending power and improve the allocation of capital. Even todays modest slowdown is causing unrest (see article (http://www.economist.com/node/21543477) ). Many people feel that too little of the countrys spectacular growth is trickling down to them. Migrant workers who seek employment in the city are treated as second-class citizens, with poor access to health care and education. Land grabs by local officials are a huge source of anger. Unrestrained industrialisation is poisoning crops and people. Growing corruption is causing fury. And angry people can talk to each other, as they never could before, through the internet. Party officials cite growing unrest as evidence of the dangers of liberalisation. Migration, they argue, may be a source of growth, but it is also a cause of instability. Workers protests disrupt production and threaten prosperity. The stirrings of civil society contain the seeds of chaos. Officials are particularly alive to these dangers in a year in which a new generation of leaders will take power. That bias towards control is understandable, and not merely selfinterested. Patriots can plausibly argue that most people have plenty of space to live as individuals and value stability more than rights and freedoms: the Arab spring, after all, had few echoes in China. Yet there are rights which Chinese people evidently do want. Migrant workers would like to keep their limited rights to education, health and pensions as they move around the country. And freedom to organise can help, not hinder, the countrys economic rise. Labour unions help industrial peace by discouraging wildcat strikes. Pressure groups can keep a check on corruption. Temples, monasteries, churches and mosques can give prosperous Chinese a motive to help provide welfare. Religious and cultural organisations can offer people meaning to life beyond the insatiable hunger for rapid economic growth. Our business now Chinas bloody past has taught the Communist Party to fear chaos above all. But historys other lesson is that those who cling to absolute power end up with none. The paradox, as some within the party are coming to realise, is that for China to succeed it must move away from

the formula that has served it so well. This is a matter of more than intellectual interest to those outside China. Whether the country continues as an authoritarian colossus, stagnates, disintegrates, or, as we would wish, becomes both freer and more prosperous will not just determine Chinas future, but shape the rest of the worlds too.
from the print edition | Leaders
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