©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 18: Saving, Capital Formation, and Financial Markets

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Explain the relationship between savings and wealth 2.Recognize and work with the components of national saving 3.Understand the reasons people save 4.Discuss the reasons firms choose to invest in capital rather than financial assets 5.Analyze financial markets using the tools of supply and demand

©2012 The McGraw-Hill Companies, All Rights Reserved 3 Savings and Wealth Saving is current income minus spending on current needs  Saving rate is saving divided by income Wealth is the value of assets minus liabilities  Assets are the value that one owns  Liabilities are the debts one owes  Balance sheet is a list of assets and liabilities  Specific date  Economic unit (business, household, etc.)

©2012 The McGraw-Hill Companies, All Rights Reserved 4 Maria’s Balance Sheet, 1/1/2011 AssetsLiabilities Cash$80Student loan$3,000 Checking account1,200Credit card balance250 Shares of stock1,000 Car (market value)3,500 Furniture (market value)500 Total$6,280$3,250 Net worth$3,030

©2012 The McGraw-Hill Companies, All Rights Reserved 5 Stocks and Flows A stock variable is defined at a point in time  Wealth ■ Debt A flow variables is defined per unit of time  Income ■ Spending  Saving ■ Wage The flow of saving causes the stock of wealth to change  Every dollar a person saves adds to his wealth  A high rate of saving today leads to an improved standard of living in the future

©2012 The McGraw-Hill Companies, All Rights Reserved 6 Capital Gains and Losses Wealth changes when the value of your assets change  Capital gains increase the value of existing assets  Higher value for stock  Capital losses decreases the value of existing assets  Car accident damages bumper and front headlight Change in wealth = Saving + Capital gains – Capital losses

©2012 The McGraw-Hill Companies, All Rights Reserved 7 Maria’s Balance Sheet, 2/1/2011 AssetsLiabilities Cash$80Student loan$3,000 Checking account1,200Credit card balance250 Shares of stock1,500 Car (market value)3,500 Furniture (market value)500 Total$6,780$3,250 Net worth$3,530

©2012 The McGraw-Hill Companies, All Rights Reserved 8 National Saving and Its Components Macroeconomists are interested primarily in saving and wealth for the country as a whole. National saving includes the saving of business firms, the government, and households. Y = C + I + G + NX = aggregate income = consumption expenditure = government purchases of goods and services = investment spending = net exports

©2012 The McGraw-Hill Companies, All Rights Reserved 9 Calculate National Savings Assume NX = 0 for simplicity National savings (S) is current income less spending on current needs  Current income is GDP or Y Spending on current needs  Exclude all investment spending (I)  Most consumption and government spending is for current needs  For simplicity, we assume all of C and all of G are for current needs S = Y – C – G

©2012 The McGraw-Hill Companies, All Rights Reserved 10 National Saving, 1998 – 2007 Since 1998, national saving has fluctuated between 16% and 23% of GDP in Egypt, between 31% and 41% of GDP in Iran, and between 24% and 32% of GDP in Morocco.

©2012 The McGraw-Hill Companies, All Rights Reserved 11 Private Saving Private saving is household plus businesses saving Household's total income is Y Households pay taxes from this income  Government transfer payments increase household incomes  Transfer payments are made by the government to households without receiving any goods in return  Interest is paid to government bond holders T = Taxes – Transfers – Government interest payments

©2012 The McGraw-Hill Companies, All Rights Reserved 12 Private Saving Private saving is after-tax income less consumption S PRIVATE = Y – T – C Private saving is done by households and businesses  Household saving or personal saving is done by families and individuals  Business saving makes up the majority of private saving in the US  Business saving is revenues less operating costs less dividends to shareholders  Business saving can purchase new capital equipment

©2012 The McGraw-Hill Companies, All Rights Reserved 13 Public Saving and National Saving Public saving is the amount of the public sector's income that is not spent on current needs  Public sector income is net taxes  Public sector spending on current needs is G S PUBLIC = T – G National saving (S) is private savings plus public savings S PRIVATE + S PUBLIC = (Y – T – C) + (T – G) S = Y – C – G

©2012 The McGraw-Hill Companies, All Rights Reserved 14 The Government Budget Balanced budget occurs when government spending equals net tax receipts  Government budget surplus is the excess of government net tax collections over spending (T – G)  Budget surplus is public savings  Government budget deficit is the excess of government spending over net tax collections  Budget deficit is public dissaving

©2012 The McGraw-Hill Companies, All Rights Reserved 15 Government Receipts and Expenditures (in billions of local currency) CountryReceiptsExpendituresDifferenceReceiptsExpendituresDifference Algeria3,6724, ,5925,779-1,187 Bahrain Egypt Iran829,930884,798-54,868965,959952,05913,900 Iraq59,90576,799-16,89474,78288,741-13,959 Jordan Kuwait Lebanon12,80217,030-4,22814,22419,333-5,109 Libya Morocco Oman Qatar Saudi Arabia Sudan Syria Tunisia UAE Yemen1,2751, ,8362,

©2012 The McGraw-Hill Companies, All Rights Reserved 16 Three Components of Egyptian National Savings, 1996 – 2008

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Three Components of Moroccan National Savings, 1996 – 2007

©2012 The McGraw-Hill Companies, All Rights Reserved 18 Why Do People Save? 1.Life-cycle saving is to meet long-term objectives  Retirement ■ Purchase a home  Children's college attendance 2.Precautionary saving is for protection against setbacks  Loss of job ■ Medical emergency 3.Bequest saving is to leave an inheritance  Mainly higher income groups

©2012 The McGraw-Hill Companies, All Rights Reserved 19 Household Saving in Japan After World War II, household saving rates were 15 – 25%  Declined after 1990 Life-cycle motives are important  Long life expectancy  Retire relatively early; long retirement period  Age structure of the population favored saving  Housing prices and down payment requirements were very high  Property values decreased after 1990 Bequest saving matters; precautionary saving is low

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Saving and the Real Interest Rate Savings often take the form of financial assets that pay a return  Interest-bearing checking ■ Bonds  Savings ■ CDs  Mutual funds ■ Stocks The real interest rate (r) is the nominal interest rate (i) minus the rate of inflation (  )  The increase in purchasing power from a financial asset  Marginal benefit of the extra saving

©2012 The McGraw-Hill Companies, All Rights Reserved 21 Thrifts and Spends Families Two otherwise identical families have different savings rates  Higher savings reduces current consumption  Thrifts consume $32,000 in 1980 and Spends consume $38,000  Thrifts get more unearned income Thrifts’ income grows faster  From 1995 on, Thrifts consume more than Spends SpendsThrifts Savings Rage 5%20% Start Date 1980 End Date 2015 Real Income $40,000 Real Interest 8%

©2012 The McGraw-Hill Companies, All Rights Reserved 22 Thrifts and Spends Families By 2015  Thrifts’ consumption is $12,000 more than Spends’  Retirement savings is $385,000  Spends’ accumulated savings is $77,000

©2012 The McGraw-Hill Companies, All Rights Reserved 23 Savings in Perspective 8% is lower than the return to mutual funds since 1980 Even 5% savings is higher than typical household  Many have $5,000 + in credit card debt at high interest rates Bottom line: High savings rate pays off in the long run If people are target savers, a high interest rate lowers savings rate  To get $25,000 in five years,  Save $4,309 per year at 5% OR  Save $3,723 per year at 10% Data show higher real rates increase savings modestly

©2012 The McGraw-Hill Companies, All Rights Reserved 24 Investment and Capital Formation Investment is the creation of new capital goods and housing Firms buy new capital to increase profits  Cost – Benefit Principle  Cost is the cost of using the machine or other capital  Benefit is the value of the marginal product of the capital

©2012 The McGraw-Hill Companies, All Rights Reserved 25 Harith and the Lawn Mower Harith's lawn care business plan  Cost of lawn mower = $4,000  Interest on loan = 6%  Assume the mower can be resold for $4,000  Net revenue = $6,000 per summer  Taxes = 20%  Harith could earn $4,400 per summer after tax working elsewhere Cost – Benefit Principle indicates whether Harith should start the business

©2012 The McGraw-Hill Companies, All Rights Reserved 26 Harith and the Lawn Mower Business plan analysis Net revenue $6,000 Less taxes (20%) $1,200 Less opportunity cost $4,400 Equals VMP of lawnmower $400 Less interest (6%)$240 Equals net benefit$160 Harith should start the business

©2012 The McGraw-Hill Companies, All Rights Reserved 27 The Investment Decision Two important costs  Price of the capital goods  Real interest rates  Opportunity cost of the investment Value of the marginal product of the capital is its benefit  Net of operating and maintenance expenses and of taxes on revenues generated  Technical innovation increases benefits  Lower taxes increase benefits  Higher price of the output increases benefits

©2012 The McGraw-Hill Companies, All Rights Reserved 28 Investment in Computers, Computer technology may have driven increases in productivity since 1995

©2012 The McGraw-Hill Companies, All Rights Reserved 29 Investment in Computers Computer investment increased faster than other capital goods Unique attributes of computers are  The declining price of computing power  Computing power per dollar doubles every 18 months  The increase in the value of the marginal product of computers

©2012 The McGraw-Hill Companies, All Rights Reserved 30 Saving, Investment, and Financial Markets Supply of savings (S) is the amount of savings that would occur at each possible real interest rate (r)  The quantity supplied increases as r increases Demand for investment (I) is the amount of savings borrowed at each possible real interest rate  The quantity demanded is inversely related to r

©2012 The McGraw-Hill Companies, All Rights Reserved 31 Financial Market  Equilibrium interest rate equates the amount of saving with the investment funds demanded  If r is above equilibrium, there is a surplus of savings  If r is below equilibrium, there is a shortage of savings Saving and investment Real interest rate (%) Investment I Saving S S, I r

©2012 The McGraw-Hill Companies, All Rights Reserved 32 Financial Markets Are Markets Financial markets adjust to surpluses and shortages as any other market does  Equilibrium Principle holds Changes in factors other than real interest rates will shift the savings or investment curves  New equilibrium

©2012 The McGraw-Hill Companies, All Rights Reserved 33 Technological Improvement  New technology raises marginal productivity of capital  Increases the demand for investment funds  Movement up the savings supply curve  Higher interest rate  Higher level of savings and investment Saving and Investment Real interest rate (%) I r E S r' I' F A' A

©2012 The McGraw-Hill Companies, All Rights Reserved 34 Government Budget Deficit Increases  Government budget deficit increases  Reduces national saving  Movement up the investment curve  Higher interest rate  Lower level of savings and investment  Private investment is crowded out I Saving and investment Real interest rate (%) S r E r' F S' A A'

©2012 The McGraw-Hill Companies, All Rights Reserved 35 Increase National Saving Policymakers know the benefits of increased national saving rates  Reducing government budget deficit would increase national saving  Political problems  Increase incentives for households  Federal consumption tax  Reduce taxes on dividends and investment income Higher national saving rate leads to greater investment in new capital goods and a higher standard of living