1. Saving and Investing Hey, check out this story.

2. Say I told you at a football game that at the end of regulation the score was 6 to 6. Farm out, like, out of state, right? Just because the score is tied can we say that both teams scored their points in the same way? They may, but they may not have. Each team may have their score made up differently. Maybe one team scored a safety 3 times and the other team kicked 2 field goals. At the end they had the same score but the scores are composed of different parts. In economics we often talk about things being equal at the end of the day. But the things that are equal are made up of separate parts. One example of this is found in the model of supply and demand. At the competitive output the quantity demanded equals the quantity supplied. But demand refers to the buyer side and the things that motivate buyers and supply refers to the seller side and the things that motivate sellers. The motivations are not exactly the same. Another example would be saving and investment. The two are equal in the national economy. But saving refers to that part of income that is not consumed or taxed away. Saving can take the form of stocks, bonds, mutual funds, and cd’s, among other things. Investment includes business purchasing newly made equipment, machines and buildings. New residential construction is also included. Saving and investment have different pieces, or components.

3. Let’s start with some definitions. Saving in economics is defined as current income minus current spending. The saving rate = saving / income. Wealth = the value of assets minus value of liabilities. This is sometimes called net wealth. Assets = anything of value someone owns. Liabilities = debts one owes. What are some examples of assets?....................... What are some examples of liabilities?........................

4. Stocks and flows Some variables of interest in economics are stocks and some are flows. To understand the difference it can be useful to consider a number line with the date, or time in a more general sense, as the value on the line. Time nowlater Say you have to be at work now and you arrive at now and then you leave at now. What will your income be for now? Nothing! The reason for this is that you actually have to work for a while after the time now. Income is a flow variable and this means you have to have an interval of time in order to measure the value. But, if you work from now until later you will probably earn some income.

5. A stock variable is one that can be measured at a point in time. An example of this could be the number of earrings you have at home right now. You could also count how many you have later. The amount can be different. Saving is a flow, income is a flow and spending is a flow. Wealth is a stock, assets are a stock, and liabilities are a stock. Changes in stock variables are actually flow variables. A special asset is savings (Note the s at the end of savings). Savings represent that part of income kept as cash, or maybe in a savings account or checking account. Another asset might be a particular company’s stock, which would have been originally purchased with saving in a period. A capital gain is flow variable that means an asset’s value later in time is higher than it was earlier in time, and a capital loss is the opposite.

6. How can you become wealthier without having to work any more hours than you currently work (Even if you work zero hours)? Spend less! Change in wealth = saving + capital gains – capital losses. So, saving can make each one of us more wealthy. It is up to us. Why people save? An economic story. 1) life-cycle saving – some people do not spend all they make in one period because they know in a later period they will not have enough income to buy all they want then. So this saving is for a long term objective. Examples here include saving for retirement, or maybe for a child’s college education. 2) Precautionary saving – this is saving for protection against unexpected setbacks like illness or an apostrophe – you know, like if the roof caves in.

7. 3) Bequest saving – the saving so you can leave an inheritance. The authors point out what I think is a really interesting point – many people choose to save for one of the three reasons listed. BUT (and you can see this is a very big but, for emphasis), how much is saved is influenced by the real rate of interest. Example: Say I go out every Thursday night and spend $20. If I do not go out and spend this money and if I save it, then I am missing out on some part of life right now! But, I can use the saving later. The higher the real rate of return, the more likely it is that folks will give up the Thursday night out.

8. Saving Here we study some accounting at the national economy level.

9. Some definitions You may recall we said Y = C + I + G + NX and this meant that the production or income earned could be thought of as made up of consumption of households, investment in capital goods by business, government spending for goods and services and net exports by the rest of the world. Assume a closed economy Here we will assume a closed economy, one with no trade with other countries and thus no imports or exports. We make this assumption now not because it is true, but because we want to highlight certain details without the added complication of international trade. This means Y = C + I + G, or our production in a year can be broken up into consumption goods, investment goods and government goods (all are really goods and services).

10. Y = C + I + G can be re-arranged to have Y - C - G = I. Now, Y - C - G says take away from the national income the consumption of households and the government spending on goods and services. HEY WAIT, if there is any income left after spending at households and governments, then there has been saving. By definition saving, S, = Y – C – G. Thus, Y - C - G = S = I and so saving equals investment in an economy. This is why folks always harp on savings in America. We need savings so that investment can occur. An interesting trick You know that if you have an equation you can add and subtract a number from the equation and the equation is still true

11. If Y - C - G = S, then also S = Y - C - T + T - G, where T stands for net taxes, meaning the taxes we pay minus any money we get back in transfers from the government. Now, S = [Y - C - T] + [T - G] means saving can be broken into two parts, Y - C - T = private saving, and is made up of business saving (often called retained earnings) or household saving after consuming and paying taxes, and T - G = public saving (government saving) in a general sense.

12. What we have come up with so far is private saving + government saving = investment. Now if government saving is negative, meaning T - G < 0, or taxes are less than government spending, or we have a budget deficit, then investment will be dragged down unless the household sector picks up the slack. Similarly a budget surplus, T - G > 0, means investment can be higher, or the household saving rate can be lower. Can households have negative saving? Sure, consumption and taxes would have to be greater than income - maybe by using credit cards - and the same problem of a budget deficit would occur.

13. Saving and Investing Financial Markets

14. Starting a Business My daughter started a lemonade stand a few summers back. Wow, did she get into it. My father in-law built a wooden stand and shipped it to us. We had to assembly it, but it works great. She used one of our pitchers to mix the lemonade in and poured out into cups. When sales picked up, she bought a big cooler. So why am I telling you this story? Why not! The cooler and the stand are capital goods. My daughter had to organize production and she even had to manage labor when her friend Emma came over and worked at the stand.

15. I would like to start a retail golf merchandise store. I even called a company once – Club House 9 is the name of the joint. But I needed a boat load of cash to get started. I would have had to get display cases, cash registers and other things. These things are called capital goods and to purchase them would be called investment. In the Y = C + I + G + NX equation for GDP the I is for just the type of investment I am referring to. I could have been contributing to GDP through I. WOW! What were my options to make my part of I? I could have used my own saving. S = I! Well, I didn’t have any at the time, so I thought about other people. I thought inside my head - do other people have some saving they would give to me for investment?

16. I eventually put my dream to have a golf store on hold. Plus I got hooked on teaching. One thing I have learned is that financial markets have sprung up to help move savings from some so that others may invest, and there are organizations that assist in the process (called financial intermediaries.) The Bond Market is a system where folks who want to invest in capital goods borrow money from savers. A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Both businesses and governments issue bonds – borrow – and typically they pay back the amount borrowed (the principal) and some interest.

17. The stock market can be used to bring savers and investors together. The savers are asked to become an owner of the company by putting up money and their reward will be part of the future profits of the company. Now, the part of the stock market that is relevant here is the primary market. This is when the company issues new shares. The company gets the funds for investment in capital goods. The stock market stuff you typically hear about is the secondary market. This is where people like you and me trade our ownership shares. This part is important activity for reasons we won’t get into here. Banks are a financial intermediary and one function they have is taking the savings of some and lending out to others who want to start or expand a business.

18. A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection of various types of stocks and bonds. At this stage of the story the mutual fund is less important for investment sake. The mutual fund is important in the secondary market because folks with very little saving can buy into the fund and participate in the market as a part owner. In the past in this class folks have had trouble understanding saving and investment, or some feature of the discussion. In the accounting sense S = I. But the two are made up of different items. In the end they are equal, but the parts are very different. S is what is left after households consume and pay taxes and what part of taxes government has not spent. Investment is done by businesses and is the purchasing of capital goods – you know, computers, machines, buildings and the like.

19. Loanable Funds

20. Overview We saw in the national income accounting that S = I and then as we thought of a couple of examples of business we saw that when a firm (Okay, a potential firm) needed to buy capital goods (investment) somehow saving had to be found. In this section and the next I will present a model of loanable funds. The model is a mechanism used to explain how financial markets coordinate the economy’s saving and investment. Because we will use a model of a market, we will have supply and demand. The supply and demand here are special. Remember, by the way, that models are simplifications of the real world, but designed to highlight features of the world.

21. The Supply of Loanable Funds What can people do with their income? In a broad sense we say they can consume goods and services, pay taxes, or save. And just as if you look at different people the consumption patterns may be different, different people have different saving patterns. Some people have more cars and less house, some are the opposite. Some have big checking accounts and few bonds, some are the opposite. Whatever the form of saving, here we talk about saving. Saving will be represented by the supply of loanable funds. In general we will have 3 items that influence the amount of loanable funds from a supply perspective. Two of these influences I will informally call shifters – because when they change they shift the supply curve – and the other one I will call a move alonger – because when it changes there is a movement along a supply curve.

22. The move alonger - The Real Interest Rate I will use r to represent the real rate of interest, which you remember to be the nominal rate minus the inflation rate. A few slides ago I mentioned you can use your income to consume or save (or pay taxes). Why save? Just go pig city and consume all the income. Life is good, enjoy. Billy, what did you say? Did you say - what about the future, the proverbial rainy day? Good Billy, you are catching on. People save for things in the future (we saw three reasons before). Saving is just giving up consumption today so that consumption can occur later. Who would give up a coke today if I pay you a coke next year. Not many of us will give up today for the same amount next year. But if we can get a positive return – what we gave up plus some - then we might give up today. In other words, we would save.

23. In fact, the higher the real rate of interest, the more we expect to see a group save. This is summarized in the graph below as an upward sloping supply of loanable funds curve. r S Q r1 r2 Q1 Q2 Here S represents the supply of loanable funds and Q is loanable funds in general.

24. Special Language page I didn’t make the following up, but I hope you understand it when you are finished reading this page. On the previous page, the way we look at the graph and talk about it are the following. If the r should rise from r1 to r2 (note I mention r changing first) then Q will change from Q1 to Q2. There is movement along the curve because r has changed and the movement from Q1 to Q2 is called an increase in the quantity supplied. Similarly, there would be a decrease in the quantity supplied if the interest rate fell. Note, at this time I did not say why the interest rate might change.

25. Supply Shifters, or things that can lead to a change in supply. Tax rates on saving in the form of taxes on the interest earned and the level of the government budget are two items that we consider at this time as factors that can lead to shifts in the supply curve. Let’s consider each idea next, shall we? If you save $1 today and r is 10% then next year you will have $1.10 of purchasing power. A certain number of folks will say, dude and dudettes, with this rate we should save the amount X. But now let’s add in the idea that the government places a tax on the interest we earn. If the tax rate is 100% most say, well that is like shoveling shtuff against the tide, so we will save less than X. Now the tax rate on saving is usually not 100%, but we can see the higher the tax rate the more we could expect saving to fall. The converse is also true. The lower this tax rate is the more saving there would be.

26. In this graph, if r is r2 and the tax rate on saving is zero then I tell you the relevant supply is S1. If the tax rate is increased the supply of loanable funds will decrease and this shows up as a shift to the left of the supply curve – here to S2. r S1 Q r1 r2 Q1 Q2 Note here that the supply curve shifted but the interest rate of record is still r2 at this time. On the Q axis we have a new Q – Q1 not Q2 – but in general we say there has been a decrease in supply. You will notice I did NOT say a decrease in the quantity supplied because we reserve that language for when the real interest rate changes S2

27. Summary of tax rate impact on supply curve If tax rate on interest earned from saving is made higher the supply shifts to the left. If tax rate on interest earned from saving is made lower the supply shifts to the right. Government budget impact Remember that the supply of loanable funds is really a supply of saving. Saving in the country is private saving and public saving. Recall public saving is really the concept of looking at the government budget situation. If T – G >0 we say it is a miracle, no, I mean a government surplus. If T – G = 0 we have a balanced budget, and if T – G < 0 we have a budget deficit.

28. In general we talk about the state of public saving as T – G, but when we get specific T – G is positive, negative, or zero. Now let’s consider a change in the budget situation. If the budget starts in surplus and then the surplus becomes even larger the saving level in the economy would go up and the supply of loanable funds would shift to the right. Here is a similar story. Say the budget starts in a deficit and then the deficit shrinks. The supply of loanable funds would increase and the curve would shift to the right. The budget is still in deficit, but a smaller one so the supply of loanable funds becomes larger than what it used to be.

29. balancesurplus deficit T - G I have this arrow to show that if the deficit gets smaller or the surplus gets bigger the supply of loanable funds will shift to the right. What would you write if I had an arrow pointing to the left? (“Parker, you lazy bum, why don’t you write something,” is not something you should write here!)

30. The demand for loanable funds People who want to buy capital goods, what we mean by investment in this economics class, have to come up with funds. In my story in a previous section I had to find others who saved and I would borrow from them. We will say folks who want to invest demand loanable funds. Hey, I need to come clean about investment. I have said it is businesses buying tools to assist in production. This much is true. But investment includes new home construction. Households buy homes. Before I said households undertake consumption. Well, the one item households take that is not consumption is new residential homes. This is part of investment. For GDP, investment includes new homes. For our purposes in terms of loanable funds, businesses that want investment demand loanable funds and so do people who want to buy homes.

31. The demand for loanable funds will depend on two things – one is a shifter and one is a move alonger. The real interest rate r is the move alonger. Here is the story. The higher r is the more folks have to pay back. The more they have to pay back the less inclined they are to undertake the action. This leads to a demand for loanable funds as we see below. r Q D r2 r1 Q2 Q1 The higher the r, the lower the quantity demanded. Similarly, the lower the r, the greater the quantity demanded.

32. Investment tax credit An investment tax credit is the shifter. When businesses invest in capital goods they do so because they think they will earn profits. In fact, at a given interest rate, X dollars of funds will be demanded because that is all that will turn out profitable. What an investment tax credit does is allow businesses to reduce the tax they owe if they undertake investment. This would mean that some projects that were not profitable may now be profitable because of the tax break. The demand for loanable funds would shift to the right. If investment tax credits are reduced then we would expect the demand for loanable funds to fall and the curve shift to the left.

33. R Q D R2 R1 Q2 Q1 Demand shifts right with an increase in the investment tax credit Demand shifts left with a decrease in the investment tax credit. Loanable Funds

34. Here we look at the market interaction

35. S1 D1 r Q r1 Q1

36. Some have made the claim that you can teach a parrot economics. Just teach the parrot to say supply and demand. Well, this teaching would be a good start. On the previous screen we have a start. Notice that demand and supply are positioned and with these positions we get the market outcome of r1 and Q1. r1 is the real rate of interest and Q1 is the amount of loanable funds traded between the savers and the investors. (Hey, is Q1 the supply amount or the demand amount? It is both at this one r) We know the position of supply or demand could change and we would thus get a new r and Q. Let’s turn to that next. Say the government changes the level of the investment tax credit to a higher level. This will shift the demand for loanable funds to the right.

37. S1 D1 R Q r1 Q1 Q2 D2 r2

38. Here is how I like to look at the graph on the previous screen. 1. Start at the initial equilibrium – when we have D1 and S1, r1 and Q1 result. 2. The increase in the tax credit has the demand shift to D2. D1 is no longer relevant. You will notice I have a dashed line at the height r1 and it shows the amount the demand shifted. This amount also now represents a shortage of loanable funds. Shortages cause prices to rise. Here the price is the interest rate. r rises to r2. 3. Note the supply curve did not change here. But as r rises the quantity supplied rises and the quantity demanded falls from its new higher level to eliminate the shortage. Overall, the Q in the market rose to Q2.

39. Summary: An increase in the investment tax credit raises the interest rate and raises the amount of loanable funds traded. Next let’s look at the impact on the market when the tax rate on interest from saving is changed – we will do a reduction in the tax rate. Then you can study the government budget changing on your own and I can see how well you did on the test.

40. S1 D1 r Q r1 Q1 S2 r2 Q2

41. Here is how I like to look at the graph on the previous screen. 1. Start at the initial equilibrium – when we have D1 and S1, r1 and Q1 result. 2. The reduction in the tax rate on the interest from saving has the supply shift to S2. S1 is no longer relevant. You will notice I have a dashed line at the height r1 and it shows the amount the supply shifted. This amount also now represents a surplus of loanable funds. Surpluses cause prices to fall. Here the price is the interest rate. r falls to r2. 3. Note the demand curve did not change here. But as r falls the quantity supplied falls from its new higher level and the quantity demanded rises to eliminate the surplus. Overall, the Q in the market rose to Q2.