Saving and Capital Formation The “Engine of Economic Growth” (Investment/Growth Rate Correlation is higher than any other factor)

Wealth, Assets and Liabilities Key terminology: Assets -- anything of value that you OWN Real Assets - Tangible items: e.g. house, car, computer code (the last example shows that real assets need not be “physical”) Financial Assets -- Claim to a financial payment from someone else: e.g., cash, checking account, bonds, IOUs Liabilities -- obligation to make a financial payment to someone else: e.g., credit card debt, student loan, mortgage. Wealth -- assets minus liabilities. Note that since a financial asset for one person is a financial liability to another, the wealth of a country is the same as its stock of real assets.

Balance sheet: Assets, Liabilities and Net Worth Assets Cash$ 500 Checking $ 2, 000 Treasury bond $ 5, 000 Auto$ 10, 000 Home$ 80, TOTAL$ 97, 500 Liabilities Credit Card Debt $ 5, 000 Car loan $ 3, 500 Mortgage $ 50, 000 TOTAL $ 58, 500 ======================================== Net worth = $ 97,500 - $ 58, 500 = $ 39, 000 ========================================

Saving and Wealth -- Exercise 9.3 (p. 235) Consuelo deposits $20 in the bank at the end of the week, and has charged $ 50 against her credit card. How has her wealth changed? Answer: Assets increase by $ 20; Liabilities by $ 50. Her wealth is down by $ 30. Consuelo uses $ 300 from her checking account to pay off her credit card bill. Answer:Assets decrease by $ 300 and so do liabilities. No change in wealth. Consuelo’s old car is declared a classic; its market value rises from $ 3, 500 to $ 4, 000. Since she did not “save”, can her wealth change? Answer: Yes, her wealth does go up by $500. Capital gains (or losses) can change net wealth. The economic response to a change in net wealth due to stock market changes will be very much the same as to a change in net wealth due to savings.

Saving: motives and behavior Life-cycle saving: buy a house, kid’s education, retirement. Probably the leading component in saving behavior. Franco Modigliani : typical pattern of behavior to borrow in youth, save in middle age, dissave in old age. Bequest motive: to leave an estate to your heirs. Saving is common among the old, presumably largely for this motive. Precautionary motive: to provide a rainy-day fund; may increase with greater worry about losing job. Demonstration effects (keeping up with Jones) may reduce saving; automatic savings plans (pension plans) may increase.

Saving and the Rate of Interest: Do higher interest rates mean more saving? Substitution effect: higher interest rates make it more desirable to substitute future consumption for present consumption -- that is, to save now and enjoy a higher standard of living in retirement. Income effect: higher interest rates make it possible to attain a retirement target (e.g., a house in Florida) with less sacrifice right now. Net result: UNCERTAIN in principle; in practice, there is probably a slight tendency for savings to increase. Answer: Maybe; economic forces pull in two directions:

Investment demand -- what determines its level? Investment = demand for new capital goods (computers, drill presses, factory buildings) Expected value marginal product of capital = VMPK (price minus other costs times marginal product of capital) “Expected” because investment NOW will not be productive until the capital goods are installed or the factory buildings are built. See text problem 8 (movie theater: how many screens?) after working with data given (net $2.00 per ticket) rework with net of $ 4 a ticket.

Demand for screens in movie theater -- (text problem 8). Screens -- Customers -- Net profit -- Marginal value product of a screen 1 40, 000$ 80, 000$ 80, , 000$ 150, 000$ 70, , 000$ 210, 000$ 60, , 000$ 260, 000 $ 50, , 000$ 300, 000$ 40, 000 At 5.5 percent interest, the interest cost for each screen will be $ 55,000. It will pay to build the first screen ($ 80,000 minus $55,000 interest costs leaves you with $ 25,000 profit) It will pay to build the second ($ 70,000 minus $ 55,000 interest costs leaves you with another $ 15,000 for $ 40,000 total profit from screens 1 and 2. The third will bring $ 5,000 more profit; but the fourth would require additional interest costs of $ 55,000 and would bring in only $ 50,000 additional profit. What happens at a higher rate of interest? At 7.5 percent, each additional screen costs $75,000 in interest -- only the first screen gets built.

Are higher interest rates a “good thing” or a “bad thing” ?? Answer: It depends on the cause of the higher rates. remember that interest rates, like prices, are a result of supply and demand, not a cause. Higher investment is a “good thing” from the point of view of economic growth, but it is compatible with either higher or lower interest rates. The first set of slides shows that increases in investment demand will lead to higher interest rates. As the U.S. economy slid into the recession of 2001, investment demand dropped, and so did interest rates (the bank prime loan rate was 9.5 percent through the last half of 2000, and dropped to 4.75 percent by February 2002) Coming out of the 2001 recession, rates rose less than many expected, but did rise: The bank prime loan rate in March 2005 was 5.5 percent.

Interest rate Supply of savings Demand for loans Quantity of loans Impact of increased investment demand New Demand for loans

Interest rate Supply of savings Demand for loans Quantity of loans Impact of decreased investment demand New Demand for loans

Interest rates and changes in the supply of savings When the supply of national savings increases, interest rates will fall. NATIONAL SAVINGS = government savings + personal savings A reduction in the government budget deficit is an increase in national savings. As the budget deficit falls, interest rates will fall and the quantity of loans demanded will increase -- hence investment by firms in real capital will increase. (see next graph) A decrease in personal savings is also a decrease in national savings. (see the graph after the next one)

Interest rate Supply of savings Demand for loans Quantity of loans Impact of decreased government budget deficit New supply

Interest rate Supply of savings Demand for loans Quantity of loans Impact of lower personal savings New supply

Gross Saving = NET SAVING = as % of Nat’l income =5.8 % 1.2 % Personal Saving = Business Saving = Government Saving = Federal = State = Gross Private Domestic Investment = Question: Does Gross Savings = Gross Investment? Why not? Data from Bureau of Economic Analysis, NIPA Table 5.1, Feb. 2005

Interest rates -- a wide variety of rates Think about why the following interest rates differ. (March 14, 2005; Federal Reserve Statistical Release H.15) Bank prime rate = 5.50 percent Mortgage rate = 5.85 percent 3-month commercial paper = 2.81 percent 3-month U.S. Treasury bills = 2.76 percent 20-year U.S. Treasury bonds = 4.93 percent AAA rated Corporate bonds = 5.35 percent BAA rated Corporate bonds = 5.97 percent