Transcript 26 - Ohio State University

Hypothetical Market Adjustment to
Great Leap Forward
How would the GLF have worked in a market economy?
•Initiating event might have been
•Increased Govt expenditure for “defense”—promote
steel production in remote locations
•Technology advance increasing profitability of small
steel manufacturing, use of scrap steel, etc.
•Use the standard macro model to work through the
impact of these initiating events.
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SAVING AND INVESTMENT IN THE
NATIONAL INCOME ACCOUNTS
• Recall that GDP is both total income in an
economy and total expenditure on the
economy’s output of goods and services:
Y = C + I + G + NX (NFI)
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Some Important Relationships
• Now, subtract C and G from both sides of the
equation:
Y – C – G =I + NFI
• The left side of the equation is the total income
in the economy after paying for consumption
and government purchases and is called
national saving, or just saving (S).
Copyright © 2004 South-Western
Summary
• National saving, or saving, can be expressed:
S = I+NFI
S=Y–C–G
S = (Y – T – C) + (T – G)= NFI + I
S = Private Saving + Public Saving
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The Market for Loanable Funds
S = I + NFI
At the equilibrium interest rate, the amount that
people want to save plus what the government
saves exactly balances the desired quantities of
investment and net foreign investment.
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The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
foreign investment)
Equilibrium
quantity
Quantity of
Loanable Funds
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How Net Foreign Investment Depends on the
Interest rate...
Real
Interest
Rate
Net foreign investment is
negative.
0
Net foreign investment is
positive.
Net Foreign
Investment
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The Market for Foreign-Currency
Exchange...
Real
Exchange
Rate
Supply of dollars
(from net foreign investment)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
The Real Equilibrium in an Open Economy
Real
Interest
Rate
(a) The Market for Loanable Funds
(b) Net Foreign Investment
Real
Supply Interest
Rate
r1
r1
Net foreign
investment,
NFI
Demand
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
Supply
E1
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
The Effects of Financing GLF with a
Government Budget Deficit
Real
Interest
Rate
(a) The Market for Loanable Funds
S2
(b) Net Foreign Investment
Real
Interest
Rate
r2
S1
B
r2
3. ...which in
turn reduces
net foreign
investment.
A
r1
r1
Demand
1. A budget deficit
reduces the supply
of loanable funds...
2. ...which
increases the
real interest...
NFI
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
E2
5. …which causes the
real exchange
rate to appreciate.
E1
S2
S1
4. The decrease in
net foreign
investment
reduces the
supply of dollars
to be exchanged
into foreign
currency…
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
An Increase in the Profitability of Backyard
Steel Furnaces
Real
Interest
Rate
r2
r1
(a) The Market for Loanable Funds
(b) Net Foreign Investment (China)
Real
Supply Interest
Rate
D2
r1
Net foreign
investment,
NFI
Demand
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
Supply
E2
E1
Demand
Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
What Actually Happened
• Backyard steel production and other projects
were not profitable.
• Therefore, it was necessary to finance them
through government procurement.
• In an open economy, this wasteful government
expenditure might (temporarily) have been
financed by investment from abroad. This at
least temporarily would have reduced starvation,
but would have paved the way for a future
financial crisis if the foreign debt couldn’t be
repayed.