Investment and Saving Chapter 9

Concepts Capital (physical capital) –tools, machines, equipment, buildings and other constructions used as means of production –A stock concept (at a given point of time) –Differs from financial capital which is the funds that used to buy and operate capital. Investment –Purchase of new capital and additions to inventories –A flow concept (for a given time period) –Gross investment vs. net investment

Concepts Continued Wealth –Value of the assets that a person owns –A stock concept Saving –Addition to wealth (the amount of income not spent) –A flow concept Financial markets –Stock markets –Bond markets –Loan markets

Determination of Real Interest Rate Investment Demand –Relationship between the amount of investment demanded and the real interest rate –Inverse relationship (downward-sloping curve) –Shift of investment demand Objective influences (business cycle, technology change, population growth) Subjective influences (animal spirits) Contagion influences

Determination of Real Interest Rate Continued Saving Supply –Relationship between the quantity saving supplied and the real interest rate –Direct relationship (upward-sloping curve) –Shift of saving supply Change in disposable income (source of saving) Purchasing power of net assets Expected future disposable income Determination of the real interest rate –By investment demand and saving supply

Government Influence on Real Interest Rate GDP (Y) –Expenditure approach: Y = C + I + G (ignoring NX) –Income approach: Y = C + S + NT –Equality of expenditure and income: C + I + G = C + S + NT  I + G = S + NT  I = S + (NT – G) Effect of government budget surplus –Increase in total saving  lower real interest rate  increase in investment. Effect of government budget deficit –Decrease in total saving  higher real interest rate  decrease in investment (crowding-out effect)