Theme 4 Saving and Investment – Closed Economy

Question 1: Multiple choice answers

Question 1.1 The real interest rate
A) is the sum of the nominal interest rate and inflation;
B) can be negative;
C) is always positive;
D) is always equal to the nominal interest rate;
E) corresponds to the depreciation rate of capital.

Question 1.2 An increase in the taxation rate on personnal income leads to

A) an increase in consumption and a decrease in saving for households;
B) an increase in consumption and saving for households;
C) a decrease in consumption and an increase of saving for households;
D) a decrease in consumption and saving for households;
E) none of the above.

Question 1.3 We expect a slowdown in economic growth, thereby affecting negatively forecasts
of future business earnings. Consequently, in a closed economy;
A) the real interest rate will increase because capital will become scarce;
B) the real interest rate will increase, because consumers will save more;
C) The real interest rate will decrease, because for society’s unchanged
saving intentions, businesses will diminish their investment decisions;
D) The real interest will increase because inflation will decrease;
E) None of the above.

Question 1.4 An increase in the real interest rate will (in a closed economy):
A) Move the supply curve of loanable funds to the left;
B) Move the demand curve of loanable funds to the right;
C) Cause a movement along the demand curve of loanable funds;
D) Increase the net present value (NPV) of investment.
Question 1.5 Which of the following statements concerning loanable funds is true?
A) An increase in private saving moves the supply curve of loanable funds to the
left;
B) A reduction in the government budget surplus increases national saving.
C) An increase in the government budget surplus causes a movement of the
supply curve of loanable funds to the right.
D) An increase in the government budget surplus causes a movement of the
supply curve of loanable funds to the left.

Question 2: The net present value of an investment project

Use the following information to answer questions 2.1 and 2.2.

We expect the following revenues (net of costs and taxes) for an investment project:

Period 0 1 2 3
Net Revenue -150 +60 +65 +70

This investment has a life span of 3 years. At the end of those 3 years, the factory will be
worthless and will stop producing.

2.1 Calculate the NPV of the project by assuming that the interest rate is 10% per year.

2.2 Explain what would happen to the NPV if:

a) the government decides to subsidize the investment;

b) the interest rate decreases.

Question 3: Saving and investment in the long term
Assume that Canadians start expecting an increase in Canadian economic growth in the future,
which will translate into more profits for firms and more income for households. Let’s also
assume that Canada is a closed economy and that this event takes place with all else being equal.

Question 3.1 Show in the appropriate graph and explain the effect of this event on the values of
investment (I), of saving (S) and of interest rates (r) in Canada.

Now assume that Canadians start expecting an economic crisis in the country. Also, keep
assuming that Canada is a closed economy and that this event takes place with all else being
equal.

Question 3.2 Show in the appropriate graph and explain the effects on the values of investment
(I), of saving (S) and of interest rates (r) in Canada.
Question 4: Causal links
Complete the 4th column of the following table by evaluating the impact of each event proposed
in the 2nd column on the variable of the 3rd column. The questions are independent from one
another. Assume that all events happen “all else being equal”. Use one of the four signs to
answers these questions:

increase: + , decrease: - , no change: 0 , uncertain : I

Event Variable Answer

Increase of the
4.1 Corporate investments
real interest rate
Decrease of the
4.2 Household saving
real interest rate
Increase in
4.3 Saving
Wealth
Strong rise in the
4.4 Saving
value of houses
Expectation of a strong
4.5 Saving
increase in households’ revenues
Strong decrease of the value of
4.6 Saving
financial assets
Gov. budget
4.7 National saving
surplus
Rise of real current personal
4.8 Real interest rate
disposable income
Rise in
4.9 Long term growth
Saving
Real interest rate (closed
4.10 Increase in gov budget deficit
economy)
Rise in the
4.11 Long term economic growth
propensity to consume
Decrease of the Productivity
4.12
taxation rate on saving (in the long term)

Question 5 : Analysis
Venezuela has strong characteristics of a closed economy. Use the data below to answer the
following questions:
5.1 Since 2009, what should be happening to the real interest rate in Venezuela?

5.2 How would your answer to 5.1 influence productivity in Venezuela?

5.3 Venezuela is a country that is dependent on oil prices. That is, a lot of firms in
Venezuela are in the oil industry. How would increasing oil prices affect the real interest rate in
Venezuela?

5.4 The following is the World Bank's forecast for the Venezuelan economy
(http://www.worldbank.org/en/country/venezuela/overview): "Venezuela faces major financing
needs, with a fiscal deficit estimated at 20 percent of GDP at the end of 2015, and external
financing needs estimated at between US$25 billion and US$35 billion. Access to external
financing is restricted and the public deficit has been largely monetized. This type of financing,
together with price controls and limitations on access to foreign currency and the participation of
the private sector in terms of providing some basic goods, have led to one of the world’s highest
inflation rates. The official rate at the end of 2015 was 180.9 percent, although unofficial
estimates are much higher."

a) Given the forecast, what should happen to the private saving in Venezuela?

b) Name at least two policies that could reduce the inflation rate in Venezuela?
SOLUTIONS

QUESTION 1: MULTIPLE CHOICE ANSWERS

Question 1.1 B) According to Fisher’s equation, i ≈ r + πa; where i is the nominal interest
rate, r is the real interest rate and πa is the inflation rate; the exponent « a »
corresponds to its anticipated value.
Following this equation, the answer cannot be A). The inflation rate is not usually
equal to 0, making D) false. The depreciation rate of capital (δ) is another concept.
Finally, when inflation is high, it may happen that the real interest rate may be
negative (the expected inflation rate being higher than the nominal interest rate – a
phenomenon observed in rare occasions in the past).

Question 1.2 D) An increase in the taxation rate on individual income leads to a decrease in
disposable personal income, which reduces consumption and saving in proportions
that depend on the propensities of both consumption and saving (see slide 14 from
the section ‘Saving and Investment’).

Question 1.3 C) By foreseeing a reduction in economic growth that negatively affects

expectations of future earnings, corporations reduce their investment decisions,
thereby decreasing the demand of loanable funds. For the same saving intentions
in society (implying an unchanged supply of a loanable funds), the real interest
rate at equilibrium decreases (see relevant slides of the section ‘Saving and
Investment’).

Question 1.4 C) A movement along the demand curve of loanable funds

Question 1.5 C) An increase in the government budget surplus causes a movement of the
supply curve of loanable funds to the right.

Question 2: The net present value of an investment project

2.1 Calculate the NPV of the project by assuming that the interest rate is 10% per year.

−150 60 65 70
𝑁𝑁𝑁𝑁𝑁𝑁 = + + + = 10.85
(1.1) 0 (1.1)1 (1.1) 2 (1.1)3

2.2 Explain what would happen to the NPV if:

a) the government decides to subsidize the investment;
The initial cost of the investment would decrease, resulting in an increase in the
numerator of the NPV and therefore the NPV itself.

b) the interest rate decreases;

This will decrease the denominators of the equation for periods 1 to 3, thereby increasing
the value of the NPV.
Question 3: Saving and investment in the long term
Question3.1
Movement of the I curve to the right (because we expect an increase in the NPV of
projects) and a movement of the S curve to the left (because we expect an increase in
future income). The interest rate increases, while the effect on the levels of S and I are
uncertain (it depends on the size of the moves of both curves).

In yellow: the initial curve.

In red: the curves following the moves.
r 𝐼𝐼2
𝑆𝑆2

𝑟𝑟2
𝐼𝐼1 𝑆𝑆1

𝑟𝑟1

S,I
Question 3.2
The curve I moves to the left (because we anticipate a decrease in the NPV of projects)
and the curve S will move to the right (because we expect to need money saved in the
upcoming months, in case of a job loss or a salary reduction). The interest rate decreases
while the effects on S and I are uncertain because we don’t know the size of the move for
each curve.
In yellow: the initial curve.
In red: the curves following the moves.
r
𝐼𝐼1 𝑆𝑆1

𝐼𝐼2 𝑆𝑆2

𝑟𝑟1

𝑟𝑟2

S,I
Question 4: causal link
Answers Explanation
- The real return has to be superior or equal to the real interest rate in order
4.1 to assess if a project is interesting. If the real interest rate increases, fewer
projects are accepted.
- By comparing the real interest rate that has decreased with the inter-
4.2 temporal preference rate, agents will prefer more present consumption
and will therefore save less.
- An increase in wealth (households’ assets minus their debts) increases
4.3
consumption, all else being equal, therefore saving decreases.
- This constitutes an example of a wealth increase; therefore the
4.4
explanation is the same as in 4.3.
- With the expected increase in income, current consumption is preferred
4.5
and saving drops.
+ This constitutes an example of wealth decrease, thereby negatively
4.6
affecting current consumption and increasing saving.
+ Public saving is included in national saving. A budget surplus signifies
4.7
positive public saving which increases national saving.
- The increase of disposable income (i.e.: a diminished taxation rate)
4.8 improves consumption and saving. When the latter increases, the supply
of loanable funds also increases, resulting in a real interest rate drop.
+ Even though in the short term, a larger propensity to save decreases
4.9 current consumption, the rise of saving ensures more investment, more
capital stock and more growth.
+ A rise of real interest rates. Public saving decreases and, therefore, saving
4.10 also decreases. In a closed economy, if saving decreases and investment
is constant, then real interest rates rise.
- A rise in the propensity of consumption brings a drop in the propensity of
4.11
saving which results in decreasing investment.
+ This will have the effect of increasing the propensity for saving, thereby
encouraging investments (through the market of loanable funds, the
4.12
supply increases and the real interest rate decreases to finally increase the
quantity of investments realized).

Question 5 : Analysis

5.1 Government deficits reduce national savings and put upward pressure on real interest
rates.

5.2 The increase in real interest rates reduces the quantity of economic investment. This in
turn would reduce capital units in Venezuela and thus reduce labour productivity.
5.3 Venezuelan firms would see their net expected profits increase, which would lead to
more economic investment. This would increase real interest rates.

5.4 a) Given the negative forecast, private households should have negative expectations
(reduction of disposable income in the future). This would reduce current consumption and
increase private saving.
5.4 b) Here are some possible answers: Getting rid of price controls, reducing limitations on the
private sector, moving to an open economy (free trade tends to put downward pressure on
prices), increasing interest rates, being less dependent on oil prices...