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CHAPTER 23
Financial Aspects of the Household, Firm,
Government, and Rest-of-the-World Sectors
Learning Objectives
 How economic and financial conditions influence household spending, saving, borrowing,
and lending
 What determines the volume of investment spending in the economy
 How firms finance current production and investment
 How the government’s spending, taxing, and borrowing affect the financial system and the
economy
 How the spending, saving, borrowing, and lending of the rest -of-the-world sector affect the
domestic financial system and the economy
Chapter Outline
I.
II.
III.
IV.
V.
VI.
To Spend or Not to Spend
Household Behavior from a Financial Perspective
A.
Asset Accumulation: Spending and Saving
B.
Liability Accumulation: Borrowing
How Economic and Financial Conditions Influence Household Accumulation of Assets and
Liabilities
Financial Aspects of Behavior of Nonfinancial Firms
A.
The Accumulation of Real Assets by Firms: Capital and Inventories
B.
The Accumulation of Liabilities by Firms
Financial Aspects of Government Behavior
A.
Financial Effects of Government Borrowing
The Rest-of-the-World Sector and Its Effect on the Financial System
A.
The Effects of International Events on the Interest Rate
Answers to Review Questions
Do assets equal liabilities for an individual househol d? For the household sector as a
whole? For the economy as a whole? Explain.
Due to the availability of credit, assets are not always equal to liabilities for an individual
household. In the household sector as a whole, assets are not always equal to liabi lities. For the
economy as whole, assets are equal to liabilities since for every asset there is a corresponding
liability.
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Both changes in income and changes in the interest rate affect spending. Which has a
greater effect? Explain.
Interest rates and income changes will affect spending. In general, changes in income have a
greater effect on spending than changes in interest rates.
Explain the effect that each of the following variables has on household and/or business
spending or saving:
a.
b.
c.
d.
e.
f.
g.
Income
Wealth
The interest rate
Capacity utilization
Expectations
Monetary policy
Tax policy
a. The household sector will spend and save more, the higher the income.
b. The more wealth, the more spending and saving by the household sector.
c. The higher the interest rate, the less spending and more saving by the household sector.
Also, the higher the interest rate, the, lower investment expenditure by the business sector.
d. If capacity utilization increases, business spending will increase
e. A change in expectations can increase or decrease household and business spending and
saving depending on the direction of the change
f. Depending on the monetary policy, household and business spending and saving can
increase or decrease.
g. An increase in taxes will reduce household and business spending, and vice versa
Define the following terms: depreciation, net investment, investment spending.
Depreciation is when an asset's value decreases. Net investment is gross investment minus
depreciation. Investment spending consists of new capital spending by business firms, changes
in inventories, and spending on newly constructed houses by households.
Is money a financial asset?
Money is a financial asset. Its uniqueness results from it being the only financial asset tha t is
also a medium of exchange.
What are some of the factors that determine whether a firm chooses internal or external
financing? How is the leverage ratio related to the borrowing constraint?
Some of the factors that determine whether a firm chooses internal or external financing are 1)
the particular type of expenditures being financed, 2) the current financial environment and
expectations about the future environment, 3) a firm's financial structure, and 4) the tax laws.
The leverage ratio is the ratio of debt to equity on a firm's balance sheet. The higher the ratio,
the more severe the borrowing constraint.
Do most college students face a borrowing constraint? Explain.
Most college students do face borrowing constraints. Since college students us ually don't make
that much money nor do they own real or financial assets, it is hard for them to seem credit
Financial Aspects of the Household, Firm, Government, and Rest-of-the-World Sectors
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worthy. However, they would like to borrow more today in anticipation of high future incomes
that their education will insure.
My income is going up, but interest rates are also higher. Will I buy a new car?
Interest rates play a big part in whether or not someone will purchase a new car. If both
interest rates and my income are going up, my decision to buy a new car will be based on how
much I need the car.
Would a firm ever use short-term debt to finance long-term capital expenditures? (Hint:
Consider all possibilities for expected long-term rates.)
Under most circumstances, firms prefer to finance long -term capital expenditures with longterm debt. The only exception would be if long term rates were very high and the firm
expected the long term rate to fall in the future. The firm may wait to procure the long term
financing until the rates fell and rely on short -term financing for the near term.
How should the government decide whether to increase or decrease its purchases of goods
and services? How does this procedure compare with the political process that is
used?
The government's decision on whether or not to change government purchases of go ods and
services should be based on whether or not the benefits of increasing or decreasing its
purchases of goods and services are greater than the costs. Unfortunately, politicians many
times base these decisions on political pressure rather than on bene fits and costs.
How will a reduction in a government deficit affect aggregate demand? Do changes in
transfer payments affect aggregate demand?
Reductions (increases) in the government deficit decrease (increase) aggregate demand.
Changes in transfer payments do not affect aggregate demand because they are merely
transferring purchasing power from one group to another.
How can government expenditures be financed?
Government expenditures can be financed either by tax increases or by the issuance of
government securities (borrowing).
Assume a constant supply of loanable funds. When government deficit spending leads to
increases in the demand for loanable funds, do interest rates always rise? Explain.
(Hint. Consider the role of expectations.)
Under normal circumstances, increases in the government deficit, ceteris paribus, push interest
rates up by increasing the demand for loanable funds. Decreases in the government deficit or
increases in a government surplus push interest rates down by decreasing the deman d for
loanable funds. Other factors operating on both the demand and the supply side of the market
for loanable funds may affect whether interest rates will indeed rise when the government
deficit rises. Expectations about the government deficit affect the interest rate, particularly for
long-term bonds, before the deficit changes. In this case, if expectations have already caused
interest rates to rise, then interest rates may not rise when the deficit actually goes up.
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Chapter 23
If the economy is at full employment and the government increases its purchases of goods
and services, does this always lead to crowding out? Is crowding out good or bad for
the economy?
Because the economy is at full employment to begin with, an increase in government purchases
of goods and services will always lead to complete crowding out. Crowding out is always bad
for the economy.
Distinguish between the public debt and a deficit.
The government is running a deficit if current government expenditures exceed current tax
receipts. The government is running a surplus if current government expenditures are less than
current tax receipts. The public debt is the sum of all past government deficits less past
surpluses.
When the Treasury issues government securities, who buys the securities?
Government securities are typically sold to financial intermediaries, market makers, and
individuals. In this case, the government has borrowed. The government securities may also be
sold to the Fed. In this case, the debt is monetized.
Will increased government spending always lead to crowding out if the economy is not at
full employment? (Be sure to consider the case when the increased spending involves
transfer payments rather than the purchase of goods and services.)
If the economy is not at full employment, then increased government spending does not
necessarily lead to crowding out if interest rates do not rise because the Fed also increases the
money supply. When increased government spending involves transfer payments rather than
the purchases of goods and services, there is no crowding out, if an increase in government
purchases of goods and services is accompanied by a large enough increase in the money
supply to keep interest rates constant.
Discuss the following statement: If the Treasury i ncreases its borrowing today, interest
rates will always go up.
If the Treasury increases its borrowing today, interest rates will not necessarily rise if the Fed
also increases the money supply.
Briefly discuss the long-term effects of government borrowing and the public debt.
The long term effect of government borrowing is a larger public debt. If the debt is owed to
ourselves and if the deficit spending was used for productive use, then it may not be
burdensome. However, if the borrowing is for frivolo us reasons, or crowds out significant
private spending, then the deficit may be burdensome. The debt can become burdensome if a
significant portion of the debt is owed to foreigners.
What is the relationship between net exports and aggregate demand? Bet ween net exports
and capital flows? If net exports increase, ceteris paribus, what happens to real GDP?
If the domestic price level increases, ceteris paribus, what happens to net exports?
There is a positive relationship between net exports and aggregate demand because net exports
are a component of aggregate demand. There is also a positive relationship between net exports
and capital flows. If net exports increase, ceteris paribus, real GDP will increase. If the
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135
domestic price level increases, ceteris paribus, net exports will decrease because prices in this
country would be higher relative to foreign prices
When the government balance is in surplus, does the government debt still have to be
rolled over? Explain.
Even if the government balance is in surplus, the government debt usually still has to be rolled
over. The outstanding public debt is much larger th an a one-year surplus and if part of the debt
that is maturing in a year is greater than the surplus, then this part of the government debt will
still have to be rolled over.
Why has the government regularized its borrowing?
The government has regularized its borrowing to minimize the disruptions that its financing
operations can cause in financial markets.
What would happen to U.S. interest rates if, ceteris paribus, foreigners decided to sell
some of the U.S. financial assets that they own?
Ceteris paribus, if foreigners decided to sell some of the U.S. financial assets that they own,
U.S. interest rates would increase.
What factors caused the capital inflow into the United States in the late 1990s? How did
this inflow affect the supply of loanable funds and the demand for dollars in
international financial markets?
Capital inflows into the United States during the late 1990s, soared for three reasons. 1) The
strong performance of the U.S. economy contributed to investor confidence, 2) Foreign
Investors were also propelled by the stellar performance of U.S. stocks, and 3) The global
financial crisis made many investors engage in capital flight or the acquisiti on of dollar
denominated assets.
Answers to Analytical Questions
Assume that Rosemarie and Jack have the following assets at the end of the year:
House
Stocks and bonds
Money
Furniture
Jewelry
Savings deposit
Car
$150,000
10,000
1,500
3,500
2,000
1,000
10,000
What is the total of their real assets? What is the total of their financial assets?
What are their total assets?
Real assets = $165,500
Financial assets = $12,500
Total assets = $178,000
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Assume that at the end of the year Rosemarie and Jack have th e following liabilities:
Mortgage loan
Credit card debt
Car loan
$120,000
4,000
6,000
What are their total liabilities?
Assuming the assets from question 25 and the above liabilities, what is their net worth?
Total liabilities = $130,000
Net worth = $48,000