CHAPTER 4
Analysis of the Financial System and the Economy
Learning Objectives




How the financial system channels and coordinates the flow of funds
The meaning and significance of consumption, saving, and investment
The role of firms and households in the output market, factor market, and financial system
The role and linkages of the various markets in coordinating and balancing firm and
household plans
 What general forces produce the activity, or motion, we observe in the economy
Chapter Outline
I.
II.
III.
IV.
The Trees versus the Forest
Spending, Saving, Borrowing, and Lending
A.
A Typical Household
B.
A Typical Firm
C.
From J.P. and APEI to the Economy as a Whole: Aggregation
The Circular Flow of Income, Expenditures, and Funds
A.
The Product Market
B.
The Factor Market
C.
The Financial System
Maximization: Plans, Revisions, and Actions
Answers to Review Questions
Using Exhibit 4-3, explain why saving is equal to investment in our hypothetical economy
with no government or foreign sector.
In this hypothetical economy, households are SSUs, while business firms are DSUs. DSUs can
only invest what is saved by SSUs; therefore, investment in Exhibit 4 -3 must be equal to
saving.
Discuss the following statement: “Only households save and only business firms invest.”
Individual households may be either SSUs or DSUs. However, most households are usually
SSUs and in the aggregate, the household sector has usually been a surplus sector. Individual
business firms may be either SSUs or DSUs. However, most business firms are us ually DSUs
and in the aggregate, the business sector is a deficit sector.
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Analysis of the Financial System and the Economy
19
What are the two uses of saving for a spending unit? Are all spending units that save
surplus spending units?
Not all spending units that save are surplus spending units. A spending unit can use saving to
purchase a newly constructed house (investment) or to lend out to DSUs. Only spending units
that have funds left over after consumption and expenditure on newly constructed homes
(investment) are surplus spending units.
Define aggregate demand and aggregate supply. What are some catalysts that would cause
aggregate demand to change? How are prices affected by a change in aggregate
demand?
Aggregate demand is the quantity of real GDP that will be demanded at various price levels.
The quantity of real output that is demanded is inversely related to the price level. Aggregate
supply is the quantity of real GDP that will be supplied at various price levels. The quantity of
real output that is supplied is directly related to the price l evel. Changes in spending by
households, firms, or the government affect aggregate demand. If aggregate demand increases,
prices rise.
Explain how the product, factor, and financial markets are similar and how they are
different. If a market is out of equilibrium, what will cause it to return to
equilibrium?
The household and business sectors meet in the product market, the factor market, and the
financial market. Households demand goods and services, supply labor and other inputs, and in
general, supply loanable funds. Businesses supply consumer goods and services, demand
investment goods, demand factor inputs, and in general, demand loanable funds. In the circular
flow, real flows go in one direction while financial flows go in the opposite. If a mark et is out
of equilibrium, price changes will occur that move the market back to equilibrium.
Use the concept of constrained maximization to explain how the behavior of households
and firms is alike.
Both households and firms are trying to maximize someth ing. Households wish to maximize
utility or satisfaction over time. Firms wish to maximize profits. In either case, the
maximization process is an effort by all spending units to do the best they can, given limited
resources or their constraints.
Suppose the Fed uses monetary policy to decrease the supply of funds available to lend
from SSUs. Explain what may happen to interest rates, prices, and real GDP.
With less funds available for lending, the interest rate will increase, prices will fall, and real
GDP will fall. Prices and output fall because of a drop in demand that results from higher
interest rates.
Explain what may happen to wages, prices, and real GDP if there is a decrease in
aggregate demand.
If there is a decrease in aggregate demand, wages, prices, and real GDP may all fall. The drop
in demand causes a surplus of goods that puts downward pressure on prices, real GDP and
wages.
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Chapter 4
John Delaney and Rosa Moore have the same annual incomes. Use the concept of
constrained maximization (and a little imagination) to explain why John might choose
to be a DSU while Rosa might choose to be an SSU.
Imagine that John Delaney's main objective is to eat at expensive restaurants every day.
Unlike Mr. Delaney, Rosa Moore's main objective is to eat at home so she can save money for
her retirement. To Ms. Moore, maximizing her utility means saving for her retirement. The fact
that she has excess funds after consumption and newly built residential investment makes her a
SSU. Maximizing his utility subject to his constraints means eating out every day for Mr.
Delaney. To achieve this objective, he might have to borrow and therefore become a DSU.
Suppose that you are the teacher and today must explain to your class what will happen if
the spending plans of various spending units do not mesh. What will you say?
If spending plans of various spending units do not mesh, price changes will occur until they do
mesh. Prices will rise in any market where there is a shortage and fall in any market where
there is a surplus. For example, suppose DSUs plan to spend more than SSUs are willing to
save. In this case, interest rates will rise and investment expenditure will fall.
If households decide to save more, will aggregate demand increase or decrease? (Hint:
Consider what will happen to interest rates and investment spending.)
If households decide to save more, aggregate demand will fall. The fall in aggregate demand
could cause interest rates to fall. The fall in interest rates could lead to increases in investment
spending (which is a component of aggregate demand) and hence increases in aggregate
demand.
Which of the following variables are stocks and which are flows: income, investment,
capital, saving, savings, consumption, GDP, and wealth.
Income – flow
Investment – flow
Capital – stock
Saving – flow
Savings – stock
Consumption – flow
GDP – flow
Wealth – stock
Answers to Analytical Questions
Draw a simple circular flow diagram between households and firms. Explain how “real”
flows of products and the services of the factors of production go in one direction
while “financial” flows of payments for products and the factor services go in the
opposite direction.
The surplus funds that the household sector has available to lend equal the deficit of the
business sector.
Analysis of the Financial System and the Economy
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Money flows from households to firms
Surplus funds flow from SSUs to DSUs
Labor and other factors flow from households to firms
Diane Weil earns wages of $45,000 and interest and dividends of $5,000. She spends
$8,000 as a down payment on a newly constructed mountain cabin and lends $4,000 in
financial markets. Assuming Diane spends the remainder of her income on
consumption, what is her saving? Is she an SSU? What is her consumption?
Saving is income minus consumption. Diane We il’s saving ($12,000) is her investment
spending ($8,000 plus the funds she lends in financial markets ($4,000). Her income is
$50,000 ($45,000 wages plus $5,000 interest and dividends). Hence she spends $38,000 on
consumption and is an SSU.
Tech Corp had gross sales of $9 million and total expenses of $8.5 million. Assume that
Tech wants to undertake a capital investment of $1 million. What is the minimum
amount of bonds it would have to issue to do so? Assume Tech pays out $300,000 in
dividends. Now what is the minimum amount it would have to borrow?
To undertake a capital investment of $1 million, Tech Corp will have to issue, at minimum,
$500,000 worth of bonds. If it pays out $300,000 in dividends, it will have to borrow, at
minimum, $800,000.
Assume the economy is composed of 200,000 households of which Diane Weil from
question 14 is average and 1,000 firms of which Tech Corp from question 15 is
average. What is disposable income? What is investment? What is saving? Are the
spending plans of the household and business sectors consistent? (Hint: Do the
surplus funds that the household sector has available to lend equal the deficit of the
business sector?)
Disposable income = $ 10 billion ($50,000 x 200,000)
Investment = $2.6 billion ($1 billion by firms (1,000 x $1 million) and $1.6 billion by
households (200,000 x $8,000) )
Assuming firms pay out $300,000 each in dividends, Saving = $2.6 billion ($2.4 billion by
households ($1,200 x 200,000 households) and $.2 billion by firms ($200 x 1,000 firms))
The surplus of the household sector does equal the deficits of the business sector.
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Chapter 4
Graph an aggregate demand curve and an aggregate supply curve. What is the
equilibrium price and the equilibrium quantity of real GDP? Demonstrate what
happens to the equilibrium price and quantity if the Fed takes action that causes
aggregate demand to fall.
The original equilibrium price and quantity are determined by the intersection of the original
AD and AS curves. The graph shows that if aggregate demand falls, the aggregate demand
curve shifts from AD to AD1. At the new point of equilibrium —where AD1 and AS intersect—
the price level and real GDP is lower than at the original equilibrium point (where AS and AD
intersect).
Assume that the Fed has been successful in reducing the level of aggregate demand. Show
graphically what will happen to the demand for loanable funds. Also show graphically
what will happen to the demand for labor.
The supply and demand for loanable funds
loanable funds
With a lower level of aggregate demand, the demand curve for loanable funds shifts from D to
D1. At the new demand curve, the demand for loanable funds has decreased.
Analysis of the Financial System and the Economy
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The demand and supply of labor
With a lower level of aggregate demand, the demand curve for labor hours shifts from D to D1.
At the new demand curve, the demand for labor hours has decreased.
Assume that the Fed has been successful in increasing the supply of loanable funds. Show
graphically what will happen to aggregate dem and and the demand for labor.
Aggregate demand and aggregate supply
With a higher level of loanable funds, the aggregate demand curve shifts from AD to AD 1. At
the new equilibrium point (intersection of AD I and AS curves) aggregate demand is greater
than at the original equilibrium point (intersection of AD and AS curves).
The demand and supply of labor
With a higher level of loanable funds, the demand curve for labor shifts from D to D1. At the
new equilibrium point (intersection of D1 and S cur ves), the quantity demand of labor is
greater than at the original equilibrium point (intersection of D and S curves).