Published on 16 Oct 2011

Department

Economics

Course

ECON102

Professor

Econ 102 Chapter 8 Notes Prof: Angela Trimarchi

Chapter 8: Saving and Investment

Recall:

Income Expenditure Identity

GDP = Y

= C + I + G + (X - M)

Assume that X=M, then:

GDP = Y

= C + I + G

Closed economy: one that does not trade and doesn’t have external links

with the rest of the world

We can rearrange the above equation to solve for I:

I = Y - C - G

We can subtract and add government taxes, T, to the right hand side of the

above equation:

I = Y – C – T – G + T

= (Y – C – T) + (T – G)

Therefore, the two main terms are the following:

(Y - C - T) = private saving

(T - G) = public saving

Therefore:

I = private saving + public saving

Government Budget

Recall:

(T – G) = public saving / government budget

T – Tax revenue

G – Government spending

If T - G > 0, then there is a budget surplus and public saving.

If: T – G < 0, then there is a budget deficit and public dis-saving.

Recall Expression for I once again:

I = Y - C - G

Y – C – G is also equal to national savings, symbol for national savings is S

Financial Markets

Bond Market

Stock Market

Econ 102 Chapter 8 Notes Prof: Angela Trimarchi

Bond Market

What is a bond?

is a certificate of indebtedness (like an IOU) which

identifies:

othe amount of debt (principal)

owhen debt will be repaid (maturity)

orate of interest

Interest rate on a ‘new’ bond depends on the:

olength of maturity

ocredit risk

Next we will look at:

Future Value of a Bond

Present Value of a Bond

Compound Interest

Discounting

Future Value

Which would you rather have?

$100 today? $100 invested at 5%

for one year

= $105 next year

Future Value

FV(j) = PV*[1 + R]j

FV : Future Value

(j) : number of compounding periods

: number of years into the future

PV : present value

R : nominal interest rate

Example:

Calculate the future value of $100 invested at 5% for 14 years.

FV (14) = (100)*(1+0.05)14

= $197.99

Discounting

Process of calculating the present value of a payment from a future

value.

The future value discounted by [1+R]j

$100 $197.99

Econ 102 Chapter 8 Notes Prof: Angela Trimarchi

Time 0 Future Time

Present Value

PV = FV(j) = FV(j) * [1+R]-j

[1+R]j

This is derived from rearranging the formula for future value.

Example:

Calculate the present value of $100 invested at 5% interest for 1 year.

PV = $100 / [1 + 0.05]1

= $100 / [1.05]

= $95.24

Calculation of j

j = ln FV

PV

ln (1 + R)

Calculation of R

R = FV 1/j

PV - 1

Question: What other formula did you learn in chapter 7 that is similar to the

formula for R? Growth Rate

Present Value of a Bond

The most someone would be willing to pay now to own the bond’s

future stream of payments

Also called the purchase price of a bond

Coupon Payment (C)

Contractual rate of interest paid on the face value of the bond

Term originated many years ago when it was customary for the bond

certificate to have interest coupons attached to its margin

At each interest payment date, the bond holder would clip off the

matured coupon and present it to the bank to receive payment in cash

Today most bonds are registered in the owner’s name and interest

payments are made by cheques sent through the mail

Present Value of a Bond =

C/[1+R]1 + C/[1+R]2 + … + C/[1+R]n + PRINC/[1+R]n

j = n

j is the number of compounding periods

PRINC = principal

Question: What is another name for the present value of a bond? Purchase

## Document Summary

= c + i + g + (x - m) Closed economy: one that does not trade and doesn"t have external links with the rest of the world. We can rearrange the above equation to solve for i: We can subtract and add government taxes, t, to the right hand side of the above equation: I = y c t g + t. = (y c t) + (t g) Therefore, the two main terms are the following: (y - c - t) = private saving (t - g) = public saving. Recall: (t g) = public saving / government budget. If t - g > 0, then there is a budget surplus and public saving. If: t g < 0, then there is a budget deficit and public dis-saving. Y c g is also equal to national savings, symbol for national savings is s.