Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Saving and Capital Formation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Importance of Saving  The resources necessary to produce new capital come primarily from a nation’s collective saving  Household saving has been relatively low recently in U.S.  However, national saving has not declined significantly. It’s made up of  Households  Businesses  Governments

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Household Saving Rate in the United States,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Saving  Saving  Current income minus spending on current needs  Saving rate  Saving divided by income

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Wealth  Wealth  The value of assets minus liabilities  Assets  Anything of value that one owns  Financial: cash, checking accounts, stocks, bonds  Real: real estate, jewelry, cars, collectibles  Liabilities  The debts one owes  Credit card balances, student loans, mortgages

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Stocks and Flows  Flow  A measure that is defined per unit of time  Saving per week  Stock  A measure that is defined at a point in time  Wealth at a particular date  A flow is the rate of change in a stock

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Capital Gains and Losses  Wealth can change due to changes in  Saving  Value of assets  Capital gains  Increases in the value of existing assets  Capital losses  Decreases in the value of existing assets

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Bull Market of the 1990’s

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Why Do People Save?  1. Life-cycle saving  Saving to meet long-term objectives  Comfortable retirement  College tuition  Buying a home or car

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Why Do People Save?  2. Precautionary saving  Saving for protection against unexpected setbacks  Loss of job  Medical emergency  3. Bequest saving  Saving done for the purpose of leaving an inheritance

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Consumption Trajectories of the Thrifts and the Spends

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Instruments for Saving  People make financial investments hoping to receive a good rate of return on the saving. Some common methods  Checking accounts  Government bonds  Shares of stock  Company retirement plans/401-k

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Real Interest Rate  Real interest rate, r  The rate at which the real purchasing power of a financial asset increases over time  Is the relevant rate of return (“reward” for saving)  Equals nominal (market) interest rate (i) minus the inflation rate (  )

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Increase Your Saving  High saving rate pays off in the long run  Due to the power of compound interest

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Higher Interest Rates  Higher real interest rates  Positive effect on saving  Increases the reward from saving, hence, more people are willing to save  Negative effect on saving  Target savers can save less and still reach their goals, hence, some can save less

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Reasons for Low Saving Rate  People often lack the self-control to do what is in their best interests  One solution is to remove the temptation to spend  Automatic saving plan deducted from each paycheck  There are increased temptations  Financial innovations have increased the temptation to save  Home equity loans  Availability of credit cards  There are demonstration effects  People use other’s spending as a yardstick

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide National Saving  National saving  Aggregate saving of the economy includes saving by  Households  Businesses  Governments

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Measuring Saving  Recall, production (income) must equal expenditure Y = C + I + G + NX  Assume NX = 0 Y = C + I + G  National saving  Current income (Y) – spending on current needs

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Current or Future?  I is not for current needs  Both C and G include spending for current needs and future needs  However, breaking up spending is very complicated  We will treat all C and G as spending for current needs  This will understate the true amount of national saving, since people do include spending for the future

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide National Saving Formula  National saving, S  The saving of the entire economy, equal to GDP less consumption expenditures and government purchases, is S = Y – C – G  Recently  U.S. household saving has fallen  U.S. business and government saving has risen

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig U.S. National Saving Rate,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Public vs. Private Saving  Private saving  Saving done by households and businesses  Public saving  Saving done by governments

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Net Taxes  Transfer payments  Payments the government makes to the public for which it receives no current goods or services in return  Social Security benefits  Farm support payments  Net Taxes  Tax revenues minus transfer payments

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Breaking Down National Saving S = Y – C – G  Equivalently »S = Y – C – G + T – T  Rearranging S = (Y – T – C) + (T – G)  We can break this down into  Private saving  Public saving S = S private + S public

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Private Saving  Private saving  The saving of the private sector of the economy is equal to the after-tax income of the private sector minus consumption expenditures S private = (Y – T – C)  Can be further broken down  Household saving  Business saving (the bulk of private saving)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Public Saving  Public saving  The saving of the government sector is equal to the net tax payments minus government purchases S public = (T – G)  Includes state and local governments

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Government Budgets  Government budget deficit  The excess of government spending over tax collections  (G – T)  Government budget surplus  The excess of government tax collections over government spending  (T – G)  Equals public saving--S public

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Three Components of National Saving,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Problematic Low Household Saving?  Problem posed by low household saving has probably been overstated  National saving, not household saving, determines the capacity of investment in new capital

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Investment and Capital Formation  National saving provides the funds needed for investment  Investment allows for the creation of new capital goods and housing  Investment is critical for increasing  Average labor productivity  Living standards

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide How Much to Invest?  Firms invest because they expect it to be profitable  A firm buys new machines if the expected marginal benefit is greater than the expected marginal cost

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Costs of Investment  The more expensive new capital is, the less investment takes place  Price of capital goods rises  Real interest rate rises  Firms borrowing funds to buy the new capital  real interest rate determines the real cost of paying the funds back  Firms not borrowing fund  real interest rate measures the opportunity cost of a capital investment

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Benefits of Investment  The increase in the value of the marginal product of the new capital  A technological advance allowing a machine to produce more output  Lower taxes  Increased output price

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Investment in Computers and Software,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Saving Equals Investment  In an economy without international borrowing and lending  National saving must equal investment  Financial markets  Bring the supply of saving into equilib- rium with the demand for saving  The real interest rate acts as the “price”

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Supply and Demand for Savings

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Supply of Savings  Supply of Savings  Shows the quantity of national saving that households, businesses, and governments are willing to supply at each value of the real interest rate  An upward-sloping curve shows that increases in the real interest rate stimulate saving

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Demand for Savings, Investment  Demand for saving, I  Shows the quantity of investment in new capital that firms would choose and hence the amount they would need to borrow in financial markets at each value of the real interest rate  A downward-sloping curve shows  That higher real interest rates raise the cost of borrowing  A reduces willingness to invest

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Effects of a New Technology on National Saving and Investment

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Effects of an Increase in Government Budget Deficit on National Saving and Investment