# Macro economics

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Macroeconomics ECO 403
VU
LESSON 09
NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
(Continued...)
Government spending, G
·
G includes government spending on goods and services.
·
G excludes transfer payments
·
Assume government spending and total taxes are exogenous:
The market for goods & services
Summarizing the Discussion so far:
Y=C+I+G
C = C(Y - T)
I = I(r)
G=G
T=T
Market for goods & services
Agg. Demand:
C(Y - T) + I(r) + G
Agg. Supply:
Y = F(K, L)
Equilibrium:
Y = C(Y - T) + I (r) + G
to equate demand with supply.
The loanable funds market
A simple supply-demand model of the financial system.
One asset:
"loanable funds"
demand for funds:  investment
supply of funds:  saving
"price" of funds:
real interest rate
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Macroeconomics ECO 403
VU
Demand for funds: Investment
The demand for loanable funds:
·
Comes from investment:
Firms borrow to finance spending on plant & equipment, new office buildings, etc.
Consumers borrow to buy new houses.
· Depends negatively on r , the "price" of loanable funds (the cost of borrowing).
Loanable funds demand curve
r
The investment curve is also the
demand curve for loanable funds.
I (r)
I
Supply of funds: Saving
The supply of loanable funds comes from saving:
·
Households use their saving to make bank deposits, purchase bonds and other assets.
These funds become available to firms to borrow to finance investment spending.
·
The government may also contribute to saving if it does not spend all of the tax
Types of saving
·
Private saving = (Y ­T) ­ C
·
Public saving =
T­G
·
National saving, S
= private saving + public saving
= (Y ­T) ­ C +  T ­ G
=
Y ­C ­G
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Macroeconomics ECO 403
VU
Digression:
Budget surpluses and deficits
·
When T > G, budget surplus = (T ­ G) = public saving
·
When T < G, budget deficit = (G ­T) and public saving is negative.
·
When T = G, budget is balanced and public saving = 0.
Budget Deficit of Pakistan
(as % of GDP)
10
9
8
7
6
5
4
3
2
1
0
1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02
%
Loanable funds supply curve
r
S = Y ­ C(Y - T) - G
National saving does
not depend on r,
so the supply curve is
vertical.
S, I
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Macroeconomics ECO 403
VU
Loanable funds market equilibrium
r
S = Y ­ C(Y - T) - G
Equilibrium real
interest rate
I (r )
S, I
Equilibrium level of
investment
The special role of r
r adjusts to equilibrate the goods market and the loanable funds market simultaneously:
If L.F. market in equilibrium, then
S=I
(Y ­ C ­ G) = I
Rewriting as:
Y = C + I + G (goods market equilibrium)
Thus,
Equilibrium in Loanable funds Market
Equilibrium in goods Market
Digression: mastering models
To learn a model well, be sure to know:
1. Which of its variables are endogenous and which are exogenous.
2. For each curve in the diagram, know
­
definition
­
intuition for slope
­
all the things that can shift the curve
3. Use the model to analyze the effects of each item in 2c.
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Macroeconomics ECO 403
VU
Mastering the loanable funds model
1. Things that shift the saving curve
·  Public saving
·  Fiscal policy: changes in G or T
·  Private saving
·  Preferences
·  Tax laws that affect saving
Now you try...
·
Draw the diagram for the loanable funds model.
·
Suppose the tax laws are altered to provide more incentives for private saving.
·
What happens to the interest rate and investment?
·
(Assume that T doesn't change)
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