Notes for Session 4
Econ 201
In this session, we continue to discuss the role of government in the circular flow Model of production, income, and expenditures. We derive the savings-investment relationship and ask how are savings turned into investment. Adding Government Tax and Spending to Model II (including international trade)—detailed numerical solution Congress decides to buy 4 trucks. cars•1/2 + business trucks + gov't trucks = 10 workers Produce fewer trucks for capital investment, or fewer cars for households, or both. Let's assume domestic car production falls by 6 and business trucks by 1. Our economy does import 3 cars and exports 2 cars, so domestic consumption of cars = 11 cars at $5000 each = $55K How will government pay for trucks? Congress imposes 10% tax on household income (only) Let’s calculate the National Product: Auto Firms' Product Sales 10 cars @ $5k: $50,000 value of product: $50,000
Truck Firms' Product Value of Goods Produced: Sales 5 trucks @ $10,000: $50,000 The National Product (NP) is the total value of goods produced: NP = $50,000 + $50,000 = $100,000
To calculate the National Income: Auto Firms' Profits Sales 10 cars @ $5,000: $50,000 -Wages 5 workers@ $7k: 35,000 Profits (before dividends are paid) = $15,000 We assume this firm pays $5,000 in dividends and keeps the rest, UP = $10,000. [For questions in your quizzes and other tests, you will be given information on the proportion of profits the firm gives out as dividends]. Truck Firms' Profits Sales, 5 trucks @ $10,000: $50,000 - Wages, 5 workers @$7k: -35,000 = Profits (before dividends) $15,000 This firm gives all profits as dividends to HHs. Therefore its undistributed profits are $0. How does the income tax affect the financial situation of the households? It reduces the income left for consumption or savings.
Households' Income and Expenses Wages: 10 @ $7,000 $70,000 plus all Dividends $5,000+$15,000= $20,000 equals Personal Income $90,000 less Income Tax of 10% $9,000 equals Disposable Income: $81,000 - Consumption Spending (11 cars—3 are imported): $55,000 equals Personal Savings: $26,000 Government Tax revenues: $9,000 Government's Income and Expenses in Model IV equals Total Tax Revenue $9,000 less Government Spending -40,000 = Government Surplus -$31,000
A touch of reality: government may spend more than it collects in taxes! National Income by sector: Household Disposable Income + Government Tax Revenues + Firm’s Undistributed Profits National Income = $81,000 + $9,000 + $10,000 = $100,000, so National Income = National Product (calculated earlier) = $100 K How about Aggregate Expenditures (AE)? Consumption $55,000 Investment $10,000 Gov't Purchases $40,000 X-M -$5000 AE = C + I + G + X-M = $100,000 We can see that NP = NI = AE Finally, is S = Investment? We can prove the S = I identity in general: Aggregate Expenditures = National Income: Consumption + Investment + Government purchases + (X-M) Equals Disposable Income + Undistributed Profit + Tax revenues In symbols: C + I + G + (X-M)= DI + UP + T rearrange as: (DI-C) + UP + (T-G) + (M-X) = I, In words: Household (Personal) Savings + Undistributed Profits (firms’ savings) + Government Savings + foreign savings = Investment The Savings and Investment Elements of our model are: Household Sav + Business Sav + Gov’t Sav + Foreign sav = Investment (DI-C) + UP + (T-G) + (M-X) = Investment
($81K-$55K) + $10K +(-$31K) + ($5K)=$10K Government is short $31,000 and borrows from other sectors with surplus (savings) How has the economy “made room” for government trucks? Lower household consumption, and Less investment in new capital goods Is society better off than before? The concept of “twin deficits” in the 1980s (and also in 2003-2007 period where government is running large deficits again): Federal Gov had a large budget deficit. US Treasury had to offer higher rates. Rest-of-the-World (ROW) found our interest rates attractive, saved $ and lent them to U.S. Treasury. Savings by ROW is our trade “deficit”. ROW saving has (partially) financed our Government budget deficit.
How are savings turned into investment? In chapter 2, we derived the identity S
= I. Embedded in this identity is the mechanism of some kind of institutional structure that helps take savings and turn them into investment. The more advanced such an institutional structure, the smoother the process of turning savings into productive investment and the better will be chances for improved standard of living in the future. In fact, you can take a very poor economy with very little savings and if you consider (assume!) it to have a working set of financial intermediaries that take savings and turn them into productive investment. In a few years, this economy will show improved standard of living. In a few decades, it will no longer be a poor country. In this session, we discuss the role of financial intermediaries and begin the study of financial instruments, specifically bonds. [Readings are in chapter 3]. Questions that you need to think about include the following: 1. What are financial intermediaries and why do we need them? A related question to the one asked above is: Which of the following would best explain the long run (i.e., year after year) stagnation of some low income developing countries? a. The low level of savings in these economies b. Lack of development of institutions (including financial institutions) and nonexistence of a well functioning financial market.
2. Which different types of intermediaries exist? Why do we have to have so many different types of financial institutions? 3. What are financial instruments? What are "debt" and "equity" instruments? 4. Since purchase and sale of (government) bonds are an important tool of monetary policy--which constitutes a good part of our discussion in this course-- we discuss the world of bonds in detail: a. What is a bond and what are the characteristics of a bond? A bond is an IOU (I owe you!) issued by an institution or a person who would like to borrow funds from the public. The person who buys the bond is promised the full return of the loaned out funds plus some fixed interest payment at the end of a period when the bond “matures”. Bonds are also termed “fixed income” assets where the lender receives a nominally fixed (interest) income from the bond. As such, bonds have three identifying features: fixed “coupon” payment, fixed maturity, and a par (face) value in $100 denominations. Essentially, the $100 is the principal of the loan and the coupon rate is the fixed interest rate the borrower agrees to pay on the date the bond matures. For example, a one-year bond with a “coupon rate” of 5% that is purchased on October 1, 2007 will pay $105 to the lender on Oct. 1, 2008. Of course, bonds do not necessarily come in $100 denominations in reality, there are bonds with face value $500, $1000, or even tens of thousands of dollars in the market. However, for simplicity, we consider the par value at $100 where the fixed interest rate paid by the borrower of funds will be in percentage (e.g., 6% or $6 per $100 borrowed).