SESSION 3

Reading
1. This set of slides

S = Savings
= income earned but not spent (money put in the savings
account, fixed deposits, equity)
I = Investment
= addition to capital stock = money spent by firms to add to
capital used for production, wage payment etc.

Investment Spending (I) or Gross Investment

= Spending on production of goods not for present consumption,
but for future consumption
= Fixed capital formation + net acquisition of valuables +
changes in inventories
Gross capital formation
Fixed capital formation = creation of new capital goods
(also called nonresidential investment)
Net acquisition of valuables = Jewelry / works of art /
property etc.
(also called residential investment)
Changes in inventories = unsold items (final or intermediate)
(Can be positive or negative)
https://
en.wikipedia.org/wiki/Gross_private_domestic_investment

I or Gross Investment has 2 alternative definitions.

1st,

I = Gross capital formation

2nd, I = Gross capital formation + Inventories

The Aggregate Output and Definition of investment (1)

Aggregate supply of goods and services (AS)
= Value of goods and services produced in the economy
= PiQi
[where i is a final good]
= Value added in all sectors
= W + int + P + R
= Aggregate Income generated for the people (Y)
=C+S+T
Aggregate Demand for goods and services (AD)
= Total Expenditure made on firms produce
=C+I+G+X-M
Here I = Addition to capital sock
AD may or may not be = AS
If AD happens to be = AS, it is an equilibrium.

The Aggregate Output and Definition of investment (2)

GDP
= Aggregate supply of goods and services (AS)
= Value of goods and services produced in the economy
= PiQi
[where i is a final good]
= Value added in all sectors
= W + int + P + R
= Aggregate Income generated for the people (Y)
=C+S+T
GDP
= Aggregate Demand for goods and services (AD) + inventories
= Total Expenditure made on firms produce
=C+I+G+X-M

Here I = Addition to capital sock + Inventories

GDP or AS = AD + inventories
If AD happens to be = AS, inventories = 0

AD = Total expenditure made on firms produce = C + I + G +

X
M Total income earned by individuals =
AS =
C+S+T

In the equilibrium, GDP measured in either way should be

identical
So, C + I + G + X M = C + S + T
In absence of the govt. and external sector, in the current
year
C+I
Or,

I=S

C+S

Suppose, this years savings are not entirely invested

in
the will
nexthappen
year. to the GDP in the next year?
What
This yrs S > next yrs I
Expenditure will decline next year, compared to this
year.
Demand for domestic goods and services will be
reduced.
Output will fall.
Recession
If S = I, output will remain at the current level.
S=I

implies output is in equilibrium.

In presence of govt. and external sector,

C+I+G+XM=C+S+T

Or,

G-T +

X-M

Domestic saving has three uses.

1. Private investment

2. Financing budget deficit G T

3. Lending to the foreigners to finance their trade deficit
X-M

Suppose, the entire household savings is invested in

private business. The government also runs a deficit in
the budget.
What can you infer about the countrys external
economic linkages?

S=I

Either G - T = X M = 0
or
G T > 0. Budget deficit must be financed by
external borrowing.
and

X M must be < 0

That is, import bill M > Export revenue X

Trade deficit

external borrowing to finance trade deficit , as well.

China, its current account surplus and budget deficit

financing
China has a large current account surplus.
Can the Chinese government finance its budget deficit with
the current account surplus?
Can any government use current account surplus to finance
budget deficit?

Say X-M is a large positive amount. It is earned by the

trading firms as foreign currency or $. These firms
exchange the $, to get domestic currency, from the
Central Bank. So some $ accumulate at the central bank.
And some extra domestic currency accumulate with the
public.
The public can raise (a) Consumption or (b) Saving with
this extra money. The government may impose (c) Taxes
too.
If consumption is raised it stimulates demand. But
government cannot use the money to finance its
deficit.
If savings are raised, the government can float bonds
and borrow from the public to finance the budget
deficit. Note this does not reduce the budget deficit,
but only provides a way to finance it.
If taxes are raised, and the government is successful in
collecting more taxes, the deficit is reduced.

Exercise
If our exports are $1.2 billion and our imports are $1.7 billion
and the government has a budget deficit of $ 3 billion,
national savings $6 billion and private investment $4 billion. Is
the economy expected to grow in the near future?

S=6
I=4
G-T = 3
X-M = -0.5
S < I + (G-T) + (X-M)
Or S+T < I + G + X-M
Or C +S+T < C + I + G + X-M
Or households income last period < expenditure on firms this
period
Therefore firms can earn higher revenue this year compared
to last year. So households can also earn higher income next
period from the firms.
Hence growth is expected.

Exercise
Which of the following are included and which are excluded in
calculating this years GDP? Explain your decisions.

a. A monthly check received by a student who has been granted

a government scholarship.
b. A farmers purchase of a new tractor.
c. A plumbers purchase of a used truck.
d. The selling of a U.S. government bond that you held for the
last few months.
e. The services of a mechanic in fixing the radiator on his car.
f. A Social Security check paid by the government to a retired
store clerk.
g. The governments purchase of a new submarine for the Navy.
h. A barbers income from cutting hair.
i. Income received from the sale of Nike stock.

Solution
a. A monthly check received by a student who has been granted
a government scholarship.- NO. This is a government transfer.
b. A farmers purchase of a new tractor. YES
c. A plumbers purchase of a used truck. NO, old goods
transaction.
d. The selling of a U.S. government bond that you held for the last
few months. NO, no production only financial transaction.
e. The services of a mechanic in fixing the radiator on his car. NO
it is his own car. So its not a market transaction.
f. A Social Security check paid by the government to a retired
store clerk. - NO. This is a government transfer.
g. The governments purchase of a new submarine for the Navy.
YES
h. A barbers income from cutting hair. YES
i. Income received from the sale of Nike stock. NO, no
production only financial transaction.

Exercise

For each of the following items, write one of the following in

the space provided.
C if the item is counted as consumption.
I if the item is counted as investment.
G if the item is counted as government.
N if the item is not counted in GDP.

a. You spend $7.00 to attend a movie. ______
b. A family pays a contractor $100,000 for a house he
built for them this year. ______
c. A family pays $75,000 for a house built three years
ago. ______
d. An accountant pays a tailor $175 to sew a suit for
her. ______
e. The government increases its defense expenditures
by $1,000,000,000. ______

Solution

a. You spend $7.00 to attend a movie. - C

b. A family pays a contractor $100,000 for a house he built
for them this year. - I or C
c. A family pays $75,000 for a house built three years ago. No
d. An accountant pays a tailor $175 to sew a suit for her. - C
e. The government increases its defense expenditures by
$1,000,000,000. - G

Exercise
Consider a closed economy with a single telephone
company, Calls yours. The residents of the country make
2 million phone calls per year at a rate of 3/- per call.
One day a new phone company Cheap-calls enters the
market and charges only 2/- per call. All residents
immediately switch to Cheap-calls. They still make 2
million calls.
Cheap calls proud of their achievement posts billboards
stating. Our country has increased its national savings by
2 million per year by switching to Cheap calls.
How true is the statement?

Exercise
For each of the transactions below, what is the
contribution to current years GDP? Explain the
effects on product, income and expenditure account.
A home maker enters workforce taking a job that
will pay 20,000/- per month. The home maker
must pay 8000/- per month for a professional
child care service.
You have won a 300,000/- prize from the central
government lottery.
A Japanese company begins a subsidiary
operation in India to assemble automobiles with
imported auto parts from Japan. The production is
marketed from Japan.