Download real interest rate

Saving, Investment, and the Financial
System: Part II
A few definitions from last week
Saving:
part of a person’s income that is not used for consumption.
Investment:
purchases of new capital, such as business equipment and machinery.
The financial system
is the collection of markets and institutions that
 coordinate the economy’s savings and investment.
 direct the resources of savers into the hands of borrowers who
have good investment projects but no funds to finance them.
 consist of mainly, banks and the stock market.
The financial system
 Banks, the stock market, the bonds market and a great many other
institutions, which we collectively refer to as the financial system,
coordinate the economy’s saving and investment.
 But these are complicated things. So, we replace them by
something which we simply call:
The market for loanable funds.
(Türkçesi: Borç verilebilir fonlar piyasası!)
The market for loanable funds
We assume that the market for loanable funds is the only market for
financial transactions!
That means:
•
All savers deposit their savings in this market.
•
All borrowers take out loans from this market.
•
There is one interest rate, which is both
 the return to saving and
 the cost of borrowing.
This is a supply-demand model of the financial system.
The “price” that will balance the demand and supply in this market is
The (real) interest rate.
The market for loanable funds helps us understand
 how the financial system coordinates saving and investment
 how government policies affect saving, investment, the interest
rate.
Supply and demand for loanable funds
 The supply of loanable funds comes from …
people who have extra income they want to save and lend out.
Household savings: Supply of loanable funds
Why do people (households) save?
 For retirement
 For emergencies / bad times
 For education (university) of their children
 To buy a new home or car
Investment and the demand for loanable funds
The demand for loanable funds comes from …
Firms that profitable investment projects, and want to borrow to
fund these projects.
— also households who purchase a newly built house.
What determines the demand for loanable funds?
One key determinant of investment is the interest rate.
Investment, or the demand for loanable funds, is a downward sloping
function of the interest rate.
The graph looks something like this
Demand for loanable funds, Investment demand,
Investment function
What determines the demand for loanable funds?
One key determinant of investment is the interest rate.
Investment, or the demand for loanable funds, is a downward sloping
function of the interest rate.
 Firms invest if they expect the returns on extra investment (i.e.
profits) > the costs of borrowing funds.
 The higher the real interest rate, the higher is the cost of funds
and the lower is level of investment demand.
Supply and Demand for Loanable Funds
Financial markets work much like other markets in the economy.
 The equilibrium of the supply and demand for loanable funds
determines the real interest rate.
The real interest rate and the loanable funds
market
 The interest rate is the price of the loan.
 It is the price that borrowers (buyers) pay for loans and the price
that lenders (sellers) receive on their saving.
 The interest rate in the market for loanable funds is the real interest
rate.
What do we mean by the “real” interest rate?
 The real interest rate vs. the nominal interest rate
You deposit 1,000TL in the bank for one year.
Suppose the nominal interest rate is 9%.
This means: At the end of one year you will get 1090TL.
Suppose that the yearly inflation rate is 3.5%.
The purchasing power of your 1090TL is
1090/(1+0,035) = 1053TL
So, in one year, the purchasing power of your initial deposit has increased
from 1000TL to 1053TL
This is a 5,3% “real” increase.
This is why we say that the real interest rate is 5,3%.
A quick calculation
Real interest rate
= Nominal interest rate – rate of Inflation
= 9.0% – 3.5% = 5.5%
The purchasing power of the 1,000TL deposit has grown 5.5%.
If the nominal interest rate and the rate of inflation are both small (in
the 5 to 10% range), then we will use the following formula as an
approximation:
Real interest rate = (nominal interest rate) – (inflation rate)
From Mahfi Eğilmez’s blog:
18 Ekim 2012 Perşembe Faiz Düştü Düşmesine de
http://www.mahfiegilmez.com/2012/10/faiz-dustu-dusmesine-de.html
1.
“Türkiye'de brüt nominal mevduat faizi ortalama yüzde 8,5.
2.
Bunun vergisi yüzde 15.
3.
Bu durumda net nominal faiz yüzde 7,2 oluyor.”
 Suppose you expect the rate of inflation
to be 6% next year. Calculate the net real
interest rate.
Back to the market for loanable funds
The equilibrium in the loanable funds market
The Market for Loanable Funds
Interest
Rate
Supply - SAVERS
5%
Demand - BORROWERS
0
€1,200
Loanable Funds
(in billions of euros)
Now it’s your turn
A simple example: Savings and Investment
Y = 1,200, Exports – Imports = 0
C = 125 + 0.75(Y – T)
I = I(r) = 200 – 10r, (r is the interest rate in percentage points)
G = 150, and T = 100
Please compute consumption (C), the equilibrium real interest rate (r),
investment (I), and private and public saving, (Sp) and (Sg)
What happens to investment and the equilibrium real interest rate if G
increases to 200? (assume that T doesn’t change.)
ANSWERS
Consumption
C = 125 + 0.75 (Y – T)
= 125 + 0.75 (1200 – 100)
= 125 + 0.75 x 1100 = 950.
Savings
S =Y–C–G
= 1200 – 950 – 150 = 100,
We use the “supply = demand” condition to compute the equilibrium r:
100 = 200 – 10r 
We solve for r*: r* = 10%.
ANSWERS, continued
Private saving = Income after tax – Consumption
SP = Y – T – C
= 1200 – 100 – 950
= 150,
Public saving is tax – government expenditures
SG = T – G
= 100 – 150
= – 50.
ANSWERS, continued
As G increases to 200, private saving does not change (becauseY is
constant) but public saving decreases (because public saving = T –
G), therefore total saving decreases from 100 to 50.
The new “supply = demand” condition becomes
50 = 200 – 10r
Again, we solve for r*: r* = 15%.
The real r increases, investment level decreases.
What happens to saving and investment
when the government runs a larger budget
deficit?
The Effect of a Government Budget Deficit
Interest
Rate
S2
Supply, S1
1. A budget deficit
decreases the
supply of loanable
funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
Demand
0
€800
€1,200
Loanable Funds
(in billions of euros)
3. . . . and reduces the equilibrium
quantity of loanable funds.
Copyright©2010 South-Western
Government Budget Deficits
The budget deficit decreases the supply of loanable funds.
 The supply curve shifts to the left.
 The equilibrium interest rate increases.
 The equilibrium level of investment decreases.
Government Budget Deficits
 Government borrowing to finance the budget deficit reduces the
supply of loanable funds available to finance investment by
households and firms.
 This fall in investment is referred to as crowding out.
 The deficit borrowing crowds out private borrowers who are
trying to finance investments.
Government Budget Deficits
 When the government spends more than it receives in tax
revenues, the short fall is called the budget deficit.
 The accumulation of past budget deficits is called the government
debt.
What are the government debt levels in Turkey?
Turkey - Public Debt Stock to GDP
How does public debt level in Turkey compare with
the rest of the world?
Public Debt to GDP 2011
???
Other determinants of investment demand
Expectations
The expectations of business owners and management for future
growth and sales of their products.
What happens if improved economic conditions are expected in
future?
Another exercise using the loanable funds
market model
An Increase in the Demand for Loanable Funds
Interest
Rate
Supply
1. An improvement
In confidence
of entrepreneurs
and business
community . . .
6%
5%
2.
raises the
equilibrium
interest rate . . .
0
D2
Demand, D1
€1,200
€1,400
Loanable Funds
(in billions of euros)
3. . . . and raises the equilibrium
quantity of loanable funds.
Copyright©2010 South-Western
Debt, austerity, and Reinhart and Rogoff!
Austerity
 Austerity (measures) [Kemer sıkma politikaları]
 Government policies during a period of bad economic conditions
that reduce budget deficit using a combination of spending cuts or
tax rises.
How to revive a depressed economy?
 In the debate, debt (mostly public debt) has become the key issue.
 The
conservatives (Ken Rogoff and Carmen Reinhart) say:
The economy’s capacity for recovery is limited by too much government
borrowing.
 The liberals (Paul Krugman and Joseph Stiglitz) say:
Only faster growth rates and higher GDP will reduce the relative weight of
past debts.
Austerity will shrink demand and slow growth, making the debt burden
heavier.
Again, Reinhart and Rogoff
 Carmen Reinhart and Ken Rogoff have written a research paper on the
relationship between national debt levels and economic growth:
"Growth in a Time of Debt"
(It was published in 2010 in a most prestigious academic journal!)
 The main result was:
Countries with ratios of public debt to GDP above 90% have
their GDP decrease by about 0.1% annually.
 Reinhart and Rogoff heavily used this finding to defend/promote
austerity policies used by governments to reduce debt levels.
How do countries reduce debt levels?
They reduce government spending, and increase tax revenue.
Governments reduce spending also by cutting welfare benefits to the
low income households.
child benefit programs,
2. income support programs,
3. health benefits,
4. public education, etc.,
1.
They also reduce salaries of government employees, and payments to
the pensioners
Example: Greece
Proposed actions:
1.
cut public sector wages by up to 25%;
2.
limit lower-wage workers’ bonuses, eliminate
higher- paid workers’ bonuses
3.
don’t renew temporary workers’ contracts.
4.
increase VAT by 4%, tax on fuel, alcohol and
tobacco, new property, and gambling by 10%
5.
raise the average retirement age from 61.4 to
63.5
6.
Cut/reduce pensions.

http://www.europeaninstitute.org/Special-G-20-Issue-on-Financial-Reform/austerity-measures-in-the-eu.html
UK
Toughest public spending cuts in more than 60 years.
1. A 24% cut to the Department of Culture (includes the BBC)
2. Raise the retirement age from 65 to 66 by 2020
3. Eliminate 490,000 public sector jobs over the next four years
4. University funding cuts
5. Lower long-term unemployment benefits
6. Eliminate benefits to those who do not seek jobs
7. Reduce child benefits
8. Other funding cuts to the welfare system (Public health services)
9. The VAT tax will rise from 17.5 to 20%
Then…
 In April 2013, something funny happened.
 In an econometrics course taught by Professors Michael Ash and Robert
Pollin at the University of Massachusetts Amherst, Thomas Herndon , a
graduate student in economics, was required to replicate the calculations in a
significant work in economic literature, to demonstrate his knowledge of and
proficiency in empirical economics.
 Thomas chose the Reinhart-Rogoff paper.
But …
He couldn’t replicate the results.
No matter how many times he repeated his
calculations, he kept getting different results!
From the BBC website…
 This week, economists have been astonished to find that a famous
academic paper often used to make the case for austerity cuts
contains major errors.
 Another surprise is that the mistakes, by two eminent Harvard
professors, were spotted by a student doing his homework.
 The mistake in the paper by Reinhart and Rogoff is “a glitch in
spreadsheet coding!”
 The corrected results show that instead that countries with debt-
to-GDP ratios above 90% saw GDP growth of 2.2%, a percentage
point lower than the growth rate seen in countries with lower debtto-GDP ratios.
This is the corrected graph!
The big question is…
Causality!
Does high debt levels cause low economic growth
or …
Does low economic growth cause high debt levels?
On this question, Paul Krugman says…
 OK, Reinhart and Rogoff have said their piece. They deny
asserting that the debt-growth relationship is causal.
 But …
 They keep making statements that suggest that it is.
 They deny having been strong austerity advocates .
 But …
They were happy to enjoy the celebrity that came with their adoption as
austerian mascots, and never said anything against the “90 percent!”
rhetoric that was used to justify sharp austerity.
http://krugman.blogs.nytimes.com/2013/04/26/grasping-at-straw-men/