1. 24
Investment and Saving
CHAPTER

2. C H A P T E R C H E C K L I S T
When you have completed your study of this chapter, you will be able to
Define and explain the relationships among capital, investment, wealth, and saving. 1
Explain how investment and saving decisions are made and how these decisions interact in financial markets to determine the real interest rate and the amount of investment and saving. 2
Explain how government influences the real interest rate, investment, and saving. 3

3. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Physical capital
The tools, instruments, machines, buildings, and other constructions that have been produced in the past and that are used to produce goods and services.
Financial capital
The funds that firms use to buy and operate physical capital.

4. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Investment and Capital
Gross investment
The total amount spent on new capital goods.
Net investment
The change in the quantity of capital—equals gross investment minus depreciation.

5. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Figure 24.1 illustrates the relationship between capital and investment.
On January 1, 2006,Tom’s DVD
Burning, Inc. had DVD recording
machines valued at $30,000.

6. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
During 2006, the value of Tom machines falls by $20,000, depreciation.
He spent $30,000 on new machines—gross
investment.
Tom’s net investment was $10,000, so at the end of 2006,Tom had capital valued at $40,000.

7. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Wealth and Saving
Wealth
The value of all the things that a person owns.
Saving
The amount of income that is not paid in taxes or spent on consumption goods and services; saving adds to wealth.

8. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Financial Markets
Financial markets
The collections of households, firms, governments, banks, and other financial institutions that lend and borrow.
Global Financial Markets
Lenders seek the highest possible real interest rate, and borrowers seek the lowest possible real interest rate in a single global financial market.
This chapter presents a good chance to introduce how borrowers and savers are brought together and to emphasize the role of financial markets. Spend some time talking about stocks and bonds. Explain that these provide funds for a firm just like going to a bank. Describe that a firm could raise funds by borrowing from a bank, by issuing a bond (that students could buy), or by selling a stock (that students could buy). This will help students to see that saving by households (through putting funds in a bank, buying a stock, or buying a bond) all provide funds that firms can use to invest. Remember to highlight what investment means again (and always refer to students buying stocks and bonds as saving, not investment!). Indeed, students often are eager to talk about stocks. Your lecture will launch itself (or at least your students’ interests will be launched!) if you spend a little time introducing some basic concepts, even if you don’t intend to spend an entire lecture on the topic. You can ask your students to define a stock. Some will probably be able to respond that it represents partial ownership in a company but many, especially the younger ones, will be unaware of this basic fact. Stocks represent a claim to the profits that are made by a firm. This observation is where discussion has the potential for some interesting turning points. Some stocks trade at very high prices even when there are no earnings or else very little earnings. Currently, many biotech companies fit this description well. So what is going on here? Explain that when investors buy stocks in a company, the price they are willing to pay is based on expectations of profits that the company will earn in the future. Of course, sometimes these profits never materialize. Ask what happens to the price of these stocks when investor expectations are not met. Your students will have no trouble telling you that this will have a depressing effect on the price of these stocks.

9. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Financial markets are organized in four groups:
Stock markets
Bond markets
Short-term securities markets
Loans markets

10. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Stock Markets
Stock
A certificate of ownership and claim to the profits that a firm makes.
Stock market
A financial market in which shares of companies’ stocks are traded.

11. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Bond Markets
Bond
A promise to pay specified sums of money on specified dates; it is a debt for the issuer.
Bond market
A financial market in which bonds issued by firms and governments are traded.

12. 24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Short-Term Securities Markets
Short-term securities are commercial bills and Treasury bills—promises by large firms and government to pay an agreed sum 90 days in the future.
Loans Markets
Banks and other financial institutions lower the cost of financing firms’ capital expenditures by accepting short-term deposits and making longer-term loans.

13. 24.2 INVESTMENT, SAVING, AND INTEREST
Investment Demand
Other things remaining the same,
The higher the real interest rate, the smaller is the quantity of investment demanded
The lower the real interest rate, the greater is the quantity investment demanded.

14. 24.2 INVESTMENT, SAVING, AND INTEREST
The real interest rate is the opportunity cost of the funds used to finance the purchase of capital.
So in making their investment decision, firms compare the real rate of interest with the rate of profit they expect to earn on their new capital.
Firms invest only when they expect to earn a rate of profit that exceeds the real interest rate.
The higher the real interest rate, the fewer projects that are profitable, so the smaller is the amount of investment demanded.

15. 24.2 INVESTMENT, SAVING, AND INTEREST
Investment Demand Curve
Investment demand
The relationship between the quantity of investment demanded and the real interest rate, other things remaining the same.
Investment demand is shown by an investment demand schedule or and investment demand curve.

16. 24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.2 shows investment demand.
The table and figure show the quantity of investment demanded at five real interest rates.
Points A through E on the investment demand curve correspond to the rows in the table.

17. 24.2 INVESTMENT, SAVING, AND INTEREST
Changes in Investment Demand
When the expected rate of profit changes, investment demand changes.
Other things remaining the same, the greater the expected profit from new capital, the greater is the amount of investment.

18. 24.2 INVESTMENT, SAVING, AND INTEREST
The many influences on expected profit can be placed in three groups:
Objective influences such as the phase of the business cycle, technological change, and population growth
Subjective influences summarized in the phrase “animal spirits”
Contagion effects summarized in the phrase “irrational exuberance”

19. 24.2 INVESTMENT, SAVING, AND INTEREST
Shifts of the Investment Demand Curve
When investment demand changes, the investment demand curve shifts.

20. 24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.3 shows changes in investment demand.
1. An increase in the expected profit increases investment demand—the investment demand curve shifts rightward to ID1.
2. A decrease in the expected profit decreases investment demand—the investment demand curve shifts leftward to ID2.

21. 24.2 INVESTMENT, SAVING, AND INTEREST
Saving Supply
Other things remaining the same,
The higher the real interest rate, the greater is the quantity of saving supplied
The lower the real interest rate, the smaller is the quantity of saving supplied
The discussion of what determines saving behavior can be used to talk about social security benefits. Students usually have an idea of Social Security but don’t often understand what it is or how it works. Use this chance to explain defined‐benefit versus defined‐contribution plans. Many students will mention that social security benefits might not be available when they retire. Ask them how they might respond to the uncertainty in the availability of future benefits. At least some students will mention saving more in different forms. Spend a little time explaining some of these (such as IRAs or 401k plans). Reiterate that individuals make decisions based on expectations of future income and expectations of future needs for income.

22. 24.2 INVESTMENT, SAVING, AND INTEREST
The real interest rate is the opportunity cost of consumption expenditure.
A dollar spent is a dollar not saved, so the interest that could have been earned on that saving is forgone.

23. 24.2 INVESTMENT, SAVING, AND INTEREST
Saving Supply Curve
Saving supply
The relationship between the quantity of saving supplied and the real interest rate, other things remaining the same.
Saving supply is illustrated by a saving supply schedule or a saving supply curve.

24. 24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.4 shows saving supply.
The table and figure show the quantity of saving supplied at five real interest rates.
Points A through E on the saving supply curve correspond to the rows in the table.

25. 24.2 INVESTMENT, SAVING, AND INTEREST
Changes in Saving Supply
The three main factors that influence saving supply are
Disposable income
The buying power of net assets
Expected future disposable income

26. 24.2 INVESTMENT, SAVING, AND INTEREST
Disposable income
Income earned minus net taxes.
Other things remaining the same,
The greater a household’s disposable income, the greater is its saving.
The greater the buying power of the net assets a household has accumulated, the less it will save.
The higher a household’s expected future disposable income, the smaller is its saving.

27. 24.2 INVESTMENT, SAVING, AND INTEREST
Shifts of the Saving Supply Curve
Along the saving supply curve, all the influences on saving other than the real interest rate remain the same.
A change in any of these influences on saving changes saving supply and shifts the saving supply curve.

28. 24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.5 shows a change in saving supply.
1. The saving supply curve shifts rightward from SS0 to SS1 if:
Disposable income increases
The buying power of net assets decreases
Expected future disposable income decreases

29. 24.2 INVESTMENT, SAVING, AND INTEREST
2. The saving supply curve shifts leftward from SS0 to SS2 if:
Disposable income decreases
The buying power of net assets increases
Expected future disposable income increases

30. 24.2 INVESTMENT, SAVING, AND INTEREST
Financial Market Equilibrium
Figure 24.6 shows how the real interest rate is determined.
ID is the investment demand curve
SS is the saving supply curve

31. 24.2 INVESTMENT, SAVING, AND INTEREST
1. If the real interest rate is 8 percent a year, the quantity of investment demanded is less than the quantity of saving supplied.
2. If the real interest rate is 4 percent a year, the quantity of investment demanded exceeds the quantity of saving supplied.

32. 24.2 INVESTMENT, SAVING, AND INTEREST
3. When the real interest rate is 6 percent a year, the quantity of investment demanded equals the quantity of saving supplied.
There is neither a shortage nor a surplus of saving, and the real interest rate is at its equilibrium level.

33. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Changes in Investment and Saving
1. If investment demand increases, the real interest rate rises.
2. If saving supply increases, the real interest rate falls.
Students usually have many questions about the role of the government and the potential dangers of high budget deficits that they may have heard about on the news or in discussions at home. You might take this opportunity to discuss budget deficits in greater detail. Use the material on the Ricardo-Barro effect versus crowding out to highlight some of the controversy in the politics of budget deficits. Students can then see how the application of economic models may still lead individuals to different conclusions. You may wish to tie this to current political discussions regarding budget deficits (and specific funding requests by the government) and the effects on the economy.

34. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Government Budget and Government Saving
GDP is the sum of consumption expenditure C, investment I, government expenditure G, and net exports NX.
In the global economy, net exports are zero, so for the world as a whole:
Y = C + I + G

35. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
GDP equals total income, which is the sum of consumption expenditure C, saving S, and net taxes NT. So:
Y = C + S + NT
By combining these two ways of looking at GDP, you can see that:
C + I + G = C + S + NT

36. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Subtract C and simplify the equation to
I + G = S + NT
Now subtract G from both sides of this equation to obtain
I = S + (NT – G)
This equation tells us that investment is financed by private saving S and government saving (NT – G).
Government saving (NT – G) is also the government budget surplus.

37. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Total saving equals private saving plus government saving.
So when the government has a budget surplus, it contributes toward financing investment.
But when the government has a budget deficit, it competes with businesses for private saving and decreases the amount available for investment.
A comparison of the private saving rate to the public saving rate for the United States makes for an interesting discussion. You can compare these numbers to saving rates in other countries to provide a reference for the low saving rate in the United States. For example, see web exercise 16 for data on saving rates in the United States and some East Asian economies or for household saving rates in OECD countries go to You can also have students try to find these numbers – suggest they look specifically for private saving rates or private saving relative to disposable income. Caution them that they may have to search a bit because a general web search will bring up many bank websites with rates for saving accounts. Use these numbers to lead into a discussion of where the United States gets the funds that it uses for investment if U.S. households are not saving much. You probably do not want to go into too much detail here because the students have not yet studied international finance, but it is easy enough to mention that the United States currently borrows funds from abroad.

38. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Effect of Government Saving
A government budget surplus increases total saving supply.
To find total saving supply, we must add the government budget surplus to private saving supply.
An increase in saving supply brings a lower interest rate, which decreases the quantity of private saving supplied and increases the quantity of investment.

39. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Figure 24.8 shows the effects of government saving.
With balanced government budgets, the real interest rate is 6 percent a year and investment equals saving at $10 trillion a year.
1. A government budget surplus of $2 trillion is added to private saving to determine the saving supply curve SS.

40. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
2. The real interest rate falls to 4 percent a year.
3. Private saving decreases to $9 trillion.
4. Total saving and investment increase to $11 trillion.

41. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Government Deficit and Crowding Out
A government budget deficit works in the opposite way to the surplus. It decreases total saving.
To find total saving, subtract the government budget deficit from private saving.
A decrease in total saving brings a higher interest rate, which increases the quantity of private saving supplied but decreases investment in a crowding-out effect.

42. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Crowding-out effect
The tendency for a government budget deficit to decrease investment.

43. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
Figure 24.8 shows a crowding-out effect.
With balanced government budgets, the real interest rate is 6 percent a year and investment equals saving at $10 trillion a year.
1. A government budget deficit is negative government saving (dissaving). Subtract the government deficit from private saving to determine the saving supply curve SS.

44. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
2. The real interest rate rises to 8 percent a year,
3. Private saving increases to $11 trillion, and
4. Total saving and investment decrease to $9 trillion.
Investment is crowded out.

45. 24.3 GOVERNMENT IN THE FINANCIAL MARKET
The Ricardo-Barro Effect
The proposition that a government budget deficit has no effect on the real interest rate or investment.
The Ricardo-Barro effect operates if private saving supply changes and the private saving supply curve shifts to offset any change in government saving, so that the total saving supply is unchanged when the government budget changes.
Most economists regard this outcome unlikely.

46. Saving and Investment in YOUR Life
Think about the amount of saving you do. How much of your disposable income do you save? Do you put your savings in a bank, in the stock market, in bonds, or under the bed?
How do you think your saving will change when you graduate and get a better-paying job?
Also think about the amount of investment you do. You are investing in human capital by being in school. How are you financing your investment? What is it costing you?
You might decide to invest in an apartment rather than paying rent. How would you make such a decision?

47. APPENDIX: PRESENT VALUE24
CHAPTER

48. A P P E N D I X C H E C K L I S T
When you have completed your study of this appendix, you will be able to
Define present value, discounting, and compounding. 1
Calculate and interpret a present value. 2

49. APPENDIX: PRESENT VALUE
The present value of a future sum of money is the amount that will earn enough interest to grow to that future sum.
We calculate a present value by using a process called discounting.
The easiest way to understand discounting is to begin with opposite, compounding—converting a present sum to a future sum by earning interest.

50. APPENDIX: PRESENT VALUE
Compounding and Future Value
A future sum of money is equal to the present sum (present value) plus the interest which will accumulate in the future.
Suppose you put $100 in a savings account that earns an interest rate of 10 percent a year.
After 1 year, you will have $110 in the bank.
After 2 years, you will have $110 plus 10 percent interest on $110, which is $121.

51. APPENDIX: PRESENT VALUE
Future Value Formula
When the interest rate is 10 percent a year (r = 0.1), $100 will accumulate as follows:
After 1 year: $100  (1 + r) = $100  1.1 = $110.
After 2 years: $100  (1 + r)2 = $100  1.21 = $121.
After N years: $100  (1 + r)N

52. APPENDIX: PRESENT VALUE
Discounting and Present Value
If the interest rate is 10 percent a year (r = 0.1) and you can have either $110 one year in the future or a different amount today, what is the amount you’d accept?
You’d accept the present value of $110.
The present value of $110 is the amount if invested today at an interest rate of 10 percent a year will grow to $110 after one year.

53. APPENDIX: PRESENT VALUE
$110 = (Present value of $110)  ( ) So
Present value of $110 = $110  ( ) = $100.
Present Value Formula
To calculate the present value of a future sum
Present value = Sum 1 year later  (1 + r).
Present value = Sum 2 years later  (1 + r)2.
Present value = Sum N years later  (1 + r)2.

54. APPENDIX: PRESENT VALUE
Crucial Role of Time and the Interest Rate
Present value depends on
How far in the future the money will be received
The interest rate
Shifting the time farther into the future lowers the present value.
Raising the interest rate lowers the present value.
Many decision you make turn on present value, such as whether to pay off your credit card balance.