Economists do it with models! Part 1

The last time we used a model we were looking at a hypothetical closed-economy. The model previously proposed was the market for loanable funds and now we can do the same analysis again with the new tools that we built in the preceding posts.

So now we go back to our Savings and Investment identity, S = I and add on NCO. Therefore,
S = I + NCO

Remember what S (national savings) consists of, which is public and private savings or

(Y - t - C) + (t - G) = S = I + NCO
Private Savings + Public Savings = National Savings = Investment and Net Capital Outflow

As we discussed last time NCO should be affected by real interest rates which behaves in the following fashion. As the real interest rate rises this encourages more people to save and less people to invest. The higher rates cost people & businesses more money to borrow to finance a project so instead they can just earn a rate of return by saving it. The higher borrowing costs create a hurdle rate that makes businesses take on the fewer projects that can meet this barrier.

Now though we have the added variable of real interest rates worldwide. So we should consider how those rates will affect financial flows. Note that this is a model and may not explain what currently happens in all places at all times. In fact what I am about to say next does not at all reflect the reality in America for the past 30 years.

So you have capital either located at home (I) or abroad (NCO). Savings will then purchase capital in either places. However, NCO can be positive or negative and will thus have an affect on the market for loanable funds in the following manner (usually): When NCO > 0, NX is greater than zero and we purchase capital abroad which increases the demand for loanable funds thus keeping real interest rates down. Conversely, when NCO <> 0, while NX < 0. How can this be so? Well as the nations that export to the US garner a bunch of dollars the countries then use their US Dollars to buy US debt.

Let's dig a little deeper into this and introduce a time differential. So in a closed economy the only way for a country to increase its investment is to increase savings. That is because S = I. In an open economy because S = I + NCO the domestic citizens do not have to raise their savings to fund investment. So if the US decides to build a nuclear plant it could import the parts from France and also borrow the funds in Euros. This will increase America's Investment (I) while increasing its NCO as well. We could also term NCO as the current account, as in the current account deficit. The reason this works is because the French have decided to save more so that the resources to build the plant are freed up for America. This is a time differential or in the jargon of economists it is an intertemporal trade, in that America imports present consumption (borrowing from the French) and exports future consumption (when it pays off the French.)

This is how the American consumer was able to spend so prolifically over the past 30 years because we kept buying present consumption and paying for it with IOUs (Treasury securities) that Asia snapped up. Because of the perceived weakness of the political and economic systems the Asians were willing to save more than their American counterpart and give up higher returns for two reasons: A) their economies relied upon the US consumer buying their goods, that is their own economies could not consume as much per capita as Americans because of the lack of a social safety net & B) the US dollar is a store of wealth and unit of exchange in the global economy.

I'll end here and begin again with the model.

Savings versus Investments

Remember the scene in the Neverending Story where Atreyu must look into the Magic Mirror gate to reveal his true identity? Well savings and investment is basically the same, it is a true identity.

So when it is said that GDP equals consumption plus investment, government expenditures and net exports (NX, which will be ignored.) The right side must always equal the left side. Let's put it into equation form and figure out how we know savings equals investment.

Given:
Y= GDP
C= Consumption
G= Government Expenditures
I= Investment
NX= Net Exports, which we ignore because we are proposing a closed economy.
S= Savings
t= taxes

The equation from above is: Y=C+G+I
We can re write this to state: Y-C-G=I
So If we take GDP and subtract out consumption and government consumption we are left with Savings. Y-C-G=S and therefore S=I

We can then rework Y-C-G=S to include taxes, t. S= (Y-t-C) + (t-G). You can see that the t, taxes, cancel each other out. In this manner we can see that Private Savings equals (Y-t-C) and Public Savings equals (t-G). Or in ingles, private savings is equal to the remaining GDP after taxes and Consumption. The tax monies transfer to the government who then spend, G. If t is greater than G than there is a surplus and if not there is a deficit. When we net public and private savings, what is remaining is investment.

Thus, from earlier we can see that the financial system ensures that S=I by moving the money from people who can save it to people who can invest it.

It is important not to think of savings and investment as interchangeable words, they are not in economics. You do not invest when you buy a bond, you are saving. An entity invest when it purchases capital, such as, buildings or machinery.

Supply and Demand for Funds


The familiar supply and demand chart. This shows that as the real interest rate falls more funds are demanded. That is, business and consumers can undertake projects that will earn them more than the rate of interest charged for utilizing the funds. Conversely, less firms will loan at lower interest rates because they will not make enough return to compensate them for given their funds to risky clients. The balance is struck in this example at 1200 and a real interest rate of 5.5%. This is because the "invisible hand" will correct any meandering. Let's imagine that the real interest rate was higher than 5.5%, say 7%. What would happen? Well, more people would think that 7% was a good deal, thus they would increase the supply of savings to be invested. This would push down interest rates because of the additional supply. The market will work back to its equilibrium.

Let's examine the current situation. The financial crisis of 2007 and 2008 has now caused people to put more towards savings. The savings rate is up to 5.2% from 4% in the first quarter. This means that there has been an increase in funds that can be loaned.


In our example, we can see that the supply shifts parallel to the right. This means there is now a lower "real*" rate of interest than in the previous quarter, as the funds have moved from 1,200 to about 1,350. So the current financial crisis has encouraged households and businesses to save rather than consuming the money.

What could cause the demand curve to shift? Any encouragement of investment, say a tax credit for buying an automobile. This would cause the demand curve to parallel shift to the right as more entities used the tax credit plus a loan to purchase a new automobile.

*Real versus nominal: nominal is the quoted interest rate you see on Bloomberg, or the Wall Street Journal. The "real" rate of interest is adjusted for inflation.