Consider the following model of the saving-investment balance. In this model, the following relationship must remain in balance: S + (M-X) = I + (G-T) where,
S is domestic saving by households and businesses
M is U.S. imports of goods and services
X is U.S. exports of goods and services
I is private domestic investment in capital goods
G is total federal, state and local government spending on goods and services, and
T is the net receipt of tax revenues by federal, state and local governments
The presentation: âLesson 1: The Savings and Investment Balanceâ in this weekâs lesson can help you understand this identity better.
Clearly, as with any high-level model, there are limitations but letâs try to understand how this model functions mechanically.Consider the model of the saving-investment balance only as an algebraic accounting identity (i.e., do not consider any economic repercussions or additional complications (those can come later)), What does the model predict will happen to gross private domestic investment (I) if:
a) Domestic saving by households was to decrease, everything else remaining the same?
b) U.S. net tax receipts were to increase, everything else remaining the same?
c) There was a sudden increase in exports from the U.S., everything else remaining the same?
d) Pre-tax business profits were to increase, everything else remaining the same?
e) Federal grants to state and local governments were to disappear, everything else remaining the same?
2. Examine the note and bond yields presented below for Treasury and Corporate AAA, AA and A-rate bonds. Why do the yields differ across the securities and within securities, across time? Which premiums or market expectations most appropriately explain those differences? In particular, what accounts for the differences in rates across securities types for the same maturities? And speculate on what factor or factors can best explain why the yields rise as maturities lengthen (within particular types of bonds). Finally, do any securities look out of place and, if so, which and why?
Treasuries
2 year 0.33%
5 year 1.39%
10 year 2.64%
20 year 3.42%
Corporate, AAA
2 year 0.40%
5 year 1.77%
10 year 3.52%
20 year 4.93%
(table continues on next page)
Corporate, AA
2 year 0.63%
5 year 1.91%
10 year 3.50%
20 year 4.43%
Corporate, A
2 year 0.84%
5 year 2.15%
10 year 3.67%
20 year 4.75%
3. Suppose that today the one-year Treasury note yields 0.12% (0.0012 in decimal form), the two-year note yields 0.40% (0.0040), the three-year note yields 0.78% (0.0078), the five-year note yields 1.60% (0.0160), the seven-year note yields 2.22% (0.0222) and the ten-year note yields 2.81% (0.0281). Under the pure expectations theory with no maturity risk:
a) What is the expected yield on a one-year note delivered one year from now?
b) What is the expected yield on a one-year note delivered two years from now?
c) What is the expected yield on a three-year note delivered two years from now?
d) What is the expected yield on a two-year note delivered five years from now?
e) What is the expected yield on a five-year note delivered five years from now?
f) What is the expected yield on a seven-year note delivered three years from now?
Note: This concept is discussed in Chapter 3 of the text and in âLesson 2: More On Yield Curves and Forward Rate Determinationâ in this weekâs online materials.
4. Assume that interest rate parity holds so that future or forward exchange rates adjust to eliminate investor arbitrage profits. If interest rates in Britain are higher than corresponding interest rates in Japan, would you expect an appreciating pound or a depreciating pound in the futures (forward) market relative to the current spot market rate? In terms of the supply and demand for pounds in the spot and forward currency markets, what is implicitly occurring in each as a result of interest rate parity? Is the pound selling forward at a premium or at a discount relative to the yen? (The presentation âLesson 3: On Exchange Ratesâ from this weekâs materials can help shed light on this subject. The portion on interest rate parity later in the presentation, so stick with it. Itâs also discussed in Chapter 16.)
5. The spot market rate for the euro is 1.4059 Canadian dollars per euro. The 3-month futures (forward) rate on the euro is 1.4147 Canadian dollars per euro. The yield on a 3-month Canadian government security is 1.16 percent (0.0116 decimal), annual percentage rate (APR). The yield on a 3-month euro area security is 0.24 percent (0.0024 decimal), annual percentage rate (APR). Show that interest rate parity (IRP) does not hold by solving for the forward rate that ensures IRP. How would you take advantage of the arbitrage opportunity arising from the actual data (i.e., borrow 1,000,000 euros, convert to Canadian dollars, invest in Canada, sell the proceeds forward and then repay your loan or borrow 1,000,000 Canadian dollars, convert to euros, invest in Europe, sell the proceeds forward and then repay your loan)?
