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Tutorial 3

Tutorial 3. ECON 111. Question 1. Explain briefly the difference between debt finance and equity finance and why they are important to promote growth in a modern economy.

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Tutorial 3

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  1. Tutorial 3 ECON 111

  2. Question 1 • Explain briefly the difference between debt finance and equity finance and why they are important to promote growth in a modern economy. Debt finance is when a firm borrows money by selling bonds in the bond market or obtaining a loan from a financial intermediary like a bank. On the other hand equity finance is when a firm sells stock to savers in the financial market who will then own a share of that company in proportion to the equity bought. Both of these instruments are extremely important as the funds required for investment in an economy are raised in this manner and such investment brings about economic growth.

  3. Question 1 • Savings are of vital importance to bring about investment and economic growth in an economy. Therefore making earnings on interest tax-free would serve as an incentive for more people to save. Use a “loanable funds market” diagram to illustrate the effect of such a measure, and its impact on the economy as a whole.

  4. Investment, which is vital for economic growth, has to come through savings in an economy. Therefore it is important to reward the savers and not penalise them (as high taxes on interest income may do) for performing this vital function. The ideal incentive would be to remove tax taken from interest earnings which would, as shown in the diagram, shift the supply curve to the right showing an increase in savings.

  5. Question 1 • Explain clearly the effect of a government budget surplus on the loanable funds market and its impact on investment and economic growth of a country. You are expected to use a loanable funds market diagram to illustrate your arguments.

  6. Review 1 • What is national saving? What is private saving? What is public saving? How are these variables related? National saving is the amount of a nation's income that is not spent on consumption or government purchases. Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Public saving is the amount of tax revenue that the government has left after paying for its spending. The three variables are related because national saving equals private saving plus public saving.

  7. Question 1 When the government runs a budget surplus (T>G), savings by the government are positive, which increases the supply of loanable funds (shifts the supply curve in the loanable funds market to the right). Supply 1 Interest Rate Supply 2 Demand r1 I <= r2 L1 L2 Loanable funds

  8. Question 2 “The economies of both China and India managed to achieve a growth rate of over 10% per annum in the three years prior to 2008, in contrast to the 2% to 3% growth achieved by developed counties such as New Zealand, Australia, United Kingdom etc.” Examine this statement in detail using the concepts of: “diminishing returns to capital” and the “catch-up effect”.

  9. Question 2 • The disparity in the growth rates of China and India compared with those of developed countries such as New Zealand, Australia and the UK is due to the phenomenon of diminishing returns to capital and the catch-up effect. • The concept of diminishing returns to capital states that the benefit from an extra unit of inputs declines as the quantity of the input increases. This is because capital is subject to diminishing returns when more units of a variable factor is used with it, as workers already have adequate amounts of capital with them to produce goods and services. • This has the implication that it is easier for a country to grow fast if it starts out relatively poor, as opposed to a country that is already rich and is in possession of the required capital. This effect of initial conditions on subsequent growth is called the catch-up effect.

  10. Question 3 “A government policy to encourage investment from overseas is accepted as one of the ingredients necessary to achieve economic growth of a country such as New Zealand where savings are inadequate”. Examine this statement in the light of the action of the New Zealand government in 2007 to reject the application of the Canadian pension fund for a stake in the Auckland airport.

  11. Question 3 • As expressed in the statement countries like New Zealand require foreign investment to achieve economic growth particularly because the savings of New Zealanders are inadequate to create new investments. • The previous government along with the overseas investment committee at first approved the selling of 24% of shares in the Auckland airport to the Canadian pension fund. Funding was required for the further development of the airport and other infrastructure facilities such as hotels and a rail link from the airport to the city. After all the formalities had gone through and the Canadian Pension Fund had spent time and resources on the purchase scheme, the government ‘pulled the plug’ on the grounds that the sale could not be allowed to go through as it was a strategic asset. This not only denied the airport of the funds required for development, but also denied 50,000 Airport shareholders from obtaining a good return for their investment. • It also sent out the message to the rest of the world that New Zealand is unfriendly towards overseas investors which could result in the inability to obtain overseas funds in future as the government decision caused damage to the reputation of the country.

  12. Question 4 In the 1990s and the first decade of the 2000s, Asian investors made significant direct and portfolio investments in New Zealand. At the same time, many New Zealanders were unhappy that this investment was occurring. • In what way was it better for New Zealand to receive this Asian investment than not to receive it? • In what way would it have been better still for New Zealanders to have made this investment?

  13. Question 4 In the 1990s and the first decade of the 2000s, Asian investors made significant direct and portfolio investments in New Zealand. At the same time, many New Zealanders were unhappy that this investment was occurring. • In what way was it better for New Zealand to receive this Asian investment than not to receive it? • New Zealand benefited from Asian investment since it made our capital stock larger, increasing our economic growth. • In what way would it have been better still for New Zealanders to have made this investment?

  14. Question 4 In the 1990s and the first decade of the 2000s, Asian investors made significant direct and portfolio investments in New Zealand. At the same time, many New Zealanders were unhappy that this investment was occurring. • In what way was it better for New Zealand to receive this Asian investment than not to receive it? • In what way would it have been better still for New Zealanders to have made this investment? • It would have been better for New Zealand to make the investments itself since then it would have received the returns on the investment itself, instead of the returns going to Asia.

  15. Question 5 In many developing nations, young women have lower enrolment rates in secondary school than do young men. Describe several ways in which greater educational opportunities for young women could lead to faster economic growth in these countries. Greater educational opportunities for women could lead to faster economic growth in the countries of South Asia because increased human capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth rate because such opportunities raise the opportunity cost of having a child.

  16. EXTRA question 1 • Suppose the government borrows $10 billion more next year than this year. • Use a supply and demand diagram to analyse this policy. Does the interest rate rise or fall? • What happens to investment? To private saving? To public saving? To national saving? Compare the size of the changes to the $10 billion of extra government borrowing. • How does the elasticity of supply of loanable funds affect the size of these changes? • How does the elasticity of demand for loanable funds affect the size of these changes? • Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable fund today? Does it increase or decrease the affects you discussed in parts (a) and (b)

  17. The effect of the $10 billion increase in government borrowing • Initially, the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing by $10 billion reduces the supply of loanable funds at each interest rate by $10 billion, so the new supply curve, S2, is shown by a shift to the left of S1 by exactly $10 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing. L1-10

  18. The effect of the $10 billion increase in government borrowing • A. the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing by $10 billion reduces the supply of loanable funds at each interest rate by $10 billion, so the new supply curve, S2, is shown by a shift to the left of S1 by exactly $10 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing. S = (Y – C – G) + NFI Low  Fallen C is low ~ C ? High  Fallen C is low

  19. The effect of the $10 billion increase in government borrowing • A. the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing by $10 billion reduces the supply of loanable funds at each interest rate by $10 billion, so the new supply curve, S2, is shown by a shift to the left of S1 by exactly $10 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing. B. Since the interest rate has increased, investment and national saving decline and private saving increases. The increase in government borrowing reduces public saving. From Figure 2 you can see that total loanable funds (and thus both investment and national saving) decline by less than $10 billion, while public saving declines by $10 billion and private saving rises by less than $10 billion.

  20. C. The more elastic is the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less, as Figure 3 shows.

  21. D. The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 4 shows.

  22. E. If households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future, then people will save more so they can pay the higher future taxes, so private saving will increase, as will the supply of loanable funds. This will offset the reduction in public saving, thus reducing the amount by which the equilibrium quantity of investment and national saving decline and reducing the amount that the interest rate rises. If the rise in private saving was exactly equal to the increase in government borrowing, there would be no shift in the national saving curve, so investment, national saving, and the interest rate would all be unchanged. This is an example of Barro-Ricardian equivalence. . [See the textbook page 168 for more explanation on Barro-Ricardian.]

  23. EXTRA question 2 • What does the level of a nation’s GDP measure? What does the growth rate of GDP measure? Would you rather live in a nation with a high level of GDP and a low growth rate, or in a nation with a low level of GDP and a high growth rate? The level of a nation’s GDP measures both the total income earned in the economy and the total expenditure on the economy’s output of goods and services. Growth rate of GDP is the percentage change in GDP, which measures how much a country’s production has increased. The level of real GDP is a good gauge of economic prosperity, and the growth of real GDP is a good gauge of economic progress. You would rather live in a nation with a high level of GDP, even though it had a low growth rate, than in a nation with a low level of GDP and a high growth rate, since the level of GDP is a measure of prosperity.

  24. Extra question 3 In the 1990s and the first decade of the 2000s, Asian investors made significant direct and portfolio investments in New Zealand. At the same time, many New Zealanders were unhappy that this investment was occurring. • In what way was it better for New Zealand to receive this Asian investment than not to receive it? • In what way would it have been better still for New Zealanders to have made this investment? a) New Zealand benefited from Asian investment since it made our capital stock larger, increasing our economic growth. b) It would have been better for New Zealand to make the investments itself since then it would have received the returns on the investment itself, instead of the returns going to Asia.

  25. Extra question 4 International data show a positive correlation between political stability and economic growth. • Through what mechanism could political stability lead to strong economic growth? • Through what mechanism could strong economic growth lead to political stability? a) Political stability could lead to strong economic growth by making the country attractive to investors. The increased investment would raise economic growth b) Strong economic growth could lead to political stability because when people have high incomes they tend to be satisfied with the political system and are less likely to overthrow or change the government. However growth alone is not sufficient, the economy needs to distribute the fruits of economic growth fairly. Otherwise high level of the inequality would create political instability despite economic growth.

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