ECON 1009

INTERNATIONAL FINANCIAL INSTITUTIONS AND MARKETS

SEMESTER 1, 2021
Tutorial Seven/Week Eight

Short Tutorial Questions (one to two sentence answers)

1) What are the four elements of Gross Domestic Product?

2) Why do businesses invest? What is the main risk businesses take when they make
investments? What are the main sources of finance for business investment?

3) Identify at least four reasons why an increase in the rate of inflation from 2% to 20% per
year might be seen as a bad thing. Identify at least two reasons why a drop in the
inflation rate from 2% to -5% might be seen as a bad thing

4) What causes inflation (i) according to the quantity theory of money; (ii) according to the
social conflict theory of inflation?

Material for Group Discussion

In March 2016, Michael Kumhof, Senior Research Adviser at the Bank of England, and Zoltan Jakab,
an Economist in the International Monetary Fund’s Research Department, published an article
entitled ‘The Truth About Banks’. The following is an extract from that article.

‘Many policy prescriptions aim to encourage physical investment by promoting saving, which
is believed to finance investment. The problem with this idea is that saving does not finance
investment, financing and money creation do. Bank financing of investment projects does not
require prior saving, but the creation of new purchasing power so that investors can buy new
plants and equipment. Once purchases have been made and sellers (or those farther down
the chain of transactions) deposit the money, they become savers in the national accounts
statistics, but this saving is an accounting consequence—not an economic cause—of lending
and investment. To argue otherwise is to confuse the respective macroeconomic roles of real
resources (saving) and debt-based money (financing). Again, this point is not new; it goes back
at least to Keynes. But it seems to have been forgotten by many economists, and as a result
is overlooked in many policy debates.

The implication of these insights is that policy should place priority on an efficient financial
system that identifies and finances worthwhile projects, rather than on measures that
attempt to encourage saving, in the hope that it will finance desired investment. The
“financing through money creation” approach makes it very clear that with financing of
physical investment projects, saving will be the natural result.’

1) Does saving fund investment, or does investment facilitate saving? Explain your
answer.

2) If you personally increase the amount you save out of your income, your income
won’t be affected, and your wealth will increase. If everyone in the economy tries to
save more out of their incomes at the same time, what will happen?

3) What is loanable funds theory? What is crowding out?

4) Based on Kumhof & Jakab, what conclusions can you draw regarding loanable funds
theory and ‘crowding out’? Can crowding out ever occur? If so, under what
circumstances?

Source:

Kumhof, M & Z. Jakab, 2016 ‘The Truth about Banks’, Finance and Development, March
2016, International Monetary Fund, Washington DC, pp 50-53