1. Saving and Capital Formation

2. Chapter 22: Saving and Capital Formation
Introduction
Motives for Saving
To meet future expenditures
Protect against an economic emergency
Produce capital goods
Chapter 22: Saving and Capital Formation

3. Household Saving Rate in the United States, 1960 - 2001
Observations
Household saving has fallen dramatically
National saving has not declined in recent years
Chapter 22: Saving and Capital Formation

4. Chapter 22: Saving and Capital Formation
Savings and Wealth
Saving
Current income minus spending on current needs
Saving Rate
Saving divided by income
Chapter 22: Saving and Capital Formation

5. Chapter 22: Saving and Capital Formation
Savings and Wealth
Wealth
The value of assets minus liabilities
Assets
Anything of value that one owns
Liabilities
The debts one owes
Chapter 22: Saving and Capital Formation

6. Consuelo’s Balance Sheet
Assets
Cash $ 80
Checking account 1,200
Shares of stock 1,000
Car (market value) 3,500
Furniture (market value)
Total $6,280
Liabilities
Student loan $3,000
Credit card balance 250
______
$3,250
Net worth $3,030
Earnings ($300/wk) - Expenditures ($280/wk) = Saving ($20/wk)
Saving Rate = $20/$300 = 6.7%
Wealth ($3,030) = Liabilities ($6,280) - Assets ($3,250)
Chapter 22: Saving and Capital Formation

7. Chapter 22: Saving and Capital Formation
Savings and Wealth
Flow: A measure that is defined per unit of time
Stock: A measure that is defined at a point in time
Stocks and Flows
Saving is a flow and is defined per unit of time (saving/week).
Wealth is a stock and is defined at a point in time (wealth on a given date).
Flow is the rate of change in the stock.
Chapter 22: Saving and Capital Formation

8. Chapter 22: Saving and Capital Formation
Savings and Wealth
Stocks and Flows
Saving is a flow.
Wealth is a stock.
Every dollar a person saves adds to their wealth.
Example
The link between saving and wealth
Consuelo’s saving ($20) is a flow that increases her assets or reduces her liabilities by $20 and increases her wealth (stock) by $20.
Chapter 22: Saving and Capital Formation

9. Chapter 22: Saving and Capital Formation
Savings and Wealth
Capital Gains
Increases in the value of existing assets
Capital Losses
Decreases in the value of existing assets
Change in Wealth
Saving + Capital gains - Capital loss
Chapter 22: Saving and Capital Formation

10. Consuelo’s Balance Sheet After An Increase in the Value of Her Stocks
Assets
Cash $ 80
Checking account 1,200
Shares of stock 1,500
Car (market value) 3,500
Furniture (market value)
Total $6,780
Liabilities
Student loan $3,000
Credit card balance 250
______
$3,250
Net worth $3,530
Capital Gains
Stock value increases from $1,000 to $1,500
Assets increase by $500
Wealth increases by $500
Capital Loss
Reduces wealth
Chapter 22: Saving and Capital Formation

11. Chapter 22: Saving and Capital Formation
The Bull Market of the 1990s
Observations
During the 1990s, household saving fell while wealth rose
Households acquired stocks in the 1990s and stock prices rose
the fall in stock prices was offset by rising home values
Chapter 22: Saving and Capital Formation

12. Chapter 22: Saving and Capital Formation
Why Do People Save?
Life-Cycle Saving
Saving to meet long-term objectives, such as retirement, college attendance, or the purchase of a home.
Precautionary Saving
Saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency.
Chapter 22: Saving and Capital Formation

13. Chapter 22: Saving and Capital Formation
Why Do People Save?
Bequest Saving
Saving done for the purpose of leaving an inheritance
Why do Japanese households save so much?
Life-cycle motive
Long life expectancy
Retire relatively early
Housing prices are very high and down payment requirements are also high
Bequest motive
Parents, who live with their children after retirement, leave a large inheritance
Precautionary motive
Very high job security reduces the precautionary motive
Chapter 22: Saving and Capital Formation

14. Chapter 22: Saving and Capital Formation
Why Do People Save?
Saving and the Real Interest Rate
The higher the real rate the greater the reward from saving.
Example
By how much does a high savings rate enhance a family’s future living standard?
Chapter 22: Saving and Capital Formation

15. Consumption Trajectories of the Thrifts and the Spends
Spends save 5% & Thrifts save 20%
Real earnings for both = $40,000
Both invest in mutual funds with a real yield of 8%
By 2015, Thrifts consume $55, 774 and Spends consume $43,698
By 2015, Thrifts’ savings is $385,000 and Spends’ savings is $77,000
Chapter 22: Saving and Capital Formation

16. Chapter 22: Saving and Capital Formation
Why Do People Save?
Observation
If people are target savers, a high real interest rate may reduce saving.
Saving, Self-Control, and Demonstration Effects
Self-Control Hypothesis
People lack the self-control to save.
Chapter 22: Saving and Capital Formation

17. Chapter 22: Saving and Capital Formation
Why Do People Save?
Saving, Self-Control, and Demonstration Effects
Techniques to offset the lack of self-control and increase savings
Payroll savings
Retirement accounts with limited withdrawals
Factors that may reduce self-control and savings
Home equity loans
Credit cards with high borrowing limits
Chapter 22: Saving and Capital Formation

18. Chapter 22: Saving and Capital Formation
Why Do People Save?
Saving, Self-Control, and Demonstration Effects
Demonstration effects
People use spending by others to measure the adequacy of their own spending.
When satisfaction depends on relative living standards, an upward spiral of spending can occur, which reduces savings.
Chapter 22: Saving and Capital Formation

19. Chapter 22: Saving and Capital Formation
Why Do People Save?
Why do U.S. households save so little?
Life-cycle motive
Social security and Medicare
Low down payment requirements for home mortgages
Precautionary motive
Stable economic performance
Strong capital gains
Self-control effect
U.S. financial markets may have made it “too” easy to borrow
Demonstration effect
Increased real wage inequality
Chapter 22: Saving and Capital Formation

20. National Saving and Its Components
The Measurement of National Saving
Real income or expenditures (Y) = Consumption (C) + Investment (I) + Government (G) + Net exports (NX)
Assume NX = 0, therefore:
Y = C + I + G
Saving = Y - spending on current needs
Chapter 22: Saving and Capital Formation

21. National Saving and Its Components
The Measurement of National Saving
Determining spending on current needs
I = spending on capital goods and residential housing
C includes durable goods which may be current and future needs
G may also include current and future needs
Assume that all C and G are current need expenditures
Chapter 22: Saving and Capital Formation

22. National Saving and Its Components
The Measurement of National Saving
National Saving (S) = Y - C - G
Chapter 22: Saving and Capital Formation

23. U.S. National Savings Rate, 1960 - 2001
Chapter 22: Saving and Capital Formation

24. Gross Domestic Savings per GDP by Groups, 1990-2016
Country Groups
Avg 90-94
Avg 95-99
Avg 00-04
Avg 05-09
Avg 10-16
Arab World
18.29
24.00
33.17
39.50
33.86
Central Europe and the Baltics
22.20
21.31
20.08
22.60
23.75
East Asia & Pacific
35.79
34.15
32.97
35.82
35.00
Europe & Central Asia
23.90
23.31
23.92
24.16
23.35
European Union
22.70
22.99
22.81
22.75
22.17
Latin America & Caribbean
20.22
18.65
20.12
22.41
19.97
Middle East & North Africa
20.10
26.54
33.12
38.76
34.33
North America
19.70
20.90
18.83
17.46
16.95
South Asia
23.51
24.39
26.18
31.40
28.45
Sub-Saharan Africa
17.39
15.25
18.47
19.58
18.88
Mean
22.38
23.15
24.97
27.44
25.67
Variance
5.19
5.01
6.08
8.18
6.77
STD
2.28
2.24
2.47
2.86
2.60
Source: WDI 2017
Chapter 22: Saving and Capital Formation

25. Gross Domestic Savings per GDP by Groups, 2010-2016
2011
2012
2013
2014
2015
2016
Arab World
36.00
39.66
38.80
37.07
33.89
26.75
24.87
Central Europe and the Baltics
22.30
23.40
23.29
24.10
24.92
25.95
East Asia & Pacific
35.92
35.00
34.65
34.44
34.60
35.16
35.23
Europe & Central Asia
22.68
23.34
22.88
22.86
23.48
24.08
24.16
European Union
21.23
21.85
21.56
21.79
22.35
23.03
23.38
Latin America & Caribbean
21.82
22.07
21.18
20.15
18.96
17.98
17.62
Middle East & North Africa
35.94
39.11
37.99
36.72
34.13
28.54
27.89
North America
15.58
15.56
16.50
17.41
17.68
17.82
18.12
South Asia
31.81
29.10
27.99
27.52
28.05
27.18
27.54
Sub-Saharan Africa
21.52
21.70
21.62
18.26
18.44
15.42
15.17
Mean
26.48
27.08
26.65
26.03
25.65
24.19
23.63
Variance
7.62
8.24
7.83
7.53
6.68
5.92
5.87
STD
2.76
2.87
2.80
2.74
2.59
2.43
2.42
Source: WDI 2017
Chapter 22: Saving and Capital Formation

26. National Saving and Its Components
Private and Public Components of National Savings
National Savings (S) = Y - C - G
T (net taxes) = private-sector tax payments - transfer payments and interest payments
S = Y - C - G + T - T
S = (Y - T - C) + (T - G)
Private saving = Sprivate = Y - T - C
Public saving = Spublic = T - G
Chapter 22: Saving and Capital Formation

27. National Saving and Its Components
Private and Public Components of National Savings
Two components of private saving (Sprivate =Y - T - C)
Household (personal) saving
Business saving
Chapter 22: Saving and Capital Formation

28. National Saving and Its Components
Private and Public Components of National Savings
Spublic = T - G
Includes
Federal
State
Local
Chapter 22: Saving and Capital Formation

29. National Saving and Its Components
Private and Public Components of National Savings
S = (Y - T - C) + (T - G)
S = Sprivate + Spublic
National Saving (S) is composed of saving by households, businesses, and government (federal, state, and local)
Private
Public
Chapter 22: Saving and Capital Formation

30. National Saving and Its Components
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)
The government budget surplus equals public saving.
Chapter 22: Saving and Capital Formation

31. National Saving and Its Components
Public Saving and the Government Budget
2000 Spublic= T - G
Federal: = 2, ,828.3
State & local: = 1, ,189.8
Spublic = = 3, ,018.1
Chapter 22: Saving and Capital Formation

32. National Saving and Its Components
Public Saving and the Government Budget
Spublic= T G
Federal: = 1, ,634.7
State & local: =
Spublic = = 2,
Chapter 22: Saving and Capital Formation

33. The Three Components of National Saving, 1960- 2001
Chapter 22: Saving and Capital Formation

34. National Saving and Its Components
Is Low Household Saving a Problem?
Observations: Macroeconomic Perspective
National saving, not household saving, determines the capacity of the economy to invest in new capital goods.
National saving has been reasonably stable despite the decline in household saving.
National saving, while relatively low, has been sufficient to allow the U.S. to become one of the world’s most productive economies.
Chapter 22: Saving and Capital Formation

35. National Saving and Its Components
Is Low Household Saving a Problem?
Observations: Microeconomic Perspective
The low household saving rate signals a problem of growing inequality in wealth among U.S. households.
Chapter 22: Saving and Capital Formation

36. Investment and Capital Formation
Investment -- the creation of new capital goods and housing -- is necessary to increase average labor productivity.
National saving is the source of funding for investment.
Investment spending is undertaken if it is expected to be profitable (i.e., the benefit, or value of marginal product, exceeds the cost of the investment)
Chapter 22: Saving and Capital Formation

37. Investment and Capital Formation
Example
Should Larry buy a riding lawn mower?
Cost of lawn mower = $4,000
Interest on loan = 6%
Net revenue = $6,000
Taxes = 20%
Larry could earn $4,400 after tax elsewhere
Assume the mower can be resold for $4,000
Chapter 22: Saving and Capital Formation

38. Investment and Capital Formation
Example
Should Larry buy a riding lawn mower?
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
Chapter 22: Saving and Capital Formation

39. Investment and Capital Formation
Factors that Determine the Investment Decision
Measuring the costs
Real interest rate (opportunity cost)
Price of capital goods
Chapter 22: Saving and Capital Formation

40. Investment and Capital Formation
Factors that Determine the Investment Decision
Measuring the benefits
Value of marginal product
Operating expense
Maintenance expense
Tax liability
Influenced by the relative price of the good or service produced by the capital
Chapter 22: Saving and Capital Formation

41. Gross Capital Formation per GDP by Groups, 1990-2016
Country Groups
Avg 90-94
Avg 95-99
Avg 00-04
Avg 05-09
Avg 10-16
Arab World
22.54
21.54
21.76
25.73
26.41
Central Europe and the Baltics
22.58
24.82
24.23
26.22
22.36
East Asia & Pacific
34.42
31.99
30.24
31.63
33.05
Europe & Central Asia
23.29
21.88
21.91
22.55
20.76
European Union
22.44
21.70
21.90
22.10
19.93
Latin America & Caribbean
20.08
19.67
18.95
20.91
21.05
Middle East & North Africa
25.41
24.47
24.53
27.14
27.34
North America
20.52
22.11
21.61
19.85
South Asia
25.00
26.48
27.85
36.53
29.43
Sub-Saharan Africa
15.93
16.80
15.77
17.47
20.74
Mean
23.22
23.14
22.92
25.19
24.09
Variance
4.78
4.13
4.12
5.60
4.65
STD
2.19
2.03
2.37
2.16
Source: WDI 2017
Chapter 22: Saving and Capital Formation

42. Gross Capital Formation per GDP by Groups, 2010-2016
Country Groups
2010
2011
2012
2013
2014
2015
2016
Arab World
27.25
24.48
24.11
24.97
25.88
29.52
28.67
Central Europe and the Baltics
23.00
23.74
22.44
21.41
22.15
22.43
21.37
East Asia & Pacific
32.85
33.13
33.23
33.30
33.25
32.51
31.84
Europe & Central Asia
21.10
21.76
20.61
20.15
20.53
20.51
20.64
European Union
20.41
20.89
19.69
19.31
19.72
19.78
Latin America & Caribbean
21.36
21.81
21.96
21.92
21.15
20.11
19.03
Middle East & North Africa
28.28
26.00
26.38
25.83
26.83
30.13
27.90
North America
18.86
19.06
19.85
20.23
20.43
20.66
20.87
South Asia
37.00
36.11
35.37
31.76
32.19
30.85
2.76
Sub-Saharan Africa
19.79
20.42
21.04
21.30
21.62
20.81
20.21
Mean
24.99
24.74
24.47
24.02
24.37
24.72
20.04
Variance
6.15
5.63
5.58
4.95
4.98
5.29
10.96
STD
2.48
2.37
2.36
2.22
2.23
2.30
3.31
Source: WDI 2017
Chapter 22: Saving and Capital Formation

43. Investment and Capital Formation
Economic Naturalist
Why has investment in computers increased by so much in recent decades?
Chapter 22: Saving and Capital Formation

44. The ‟AK model” (1) How can government policies affect growth?
Let per capita income be y, (physical and human) capital per head be k, the aggregate production function is:
where A is a constant parameter of factor productivity (= marginal and average product of capital) → constant return-to-scale
Two-period model: period 1 and period 2
The rate of growth (g) is:
k1 is fixed, for it is given from the first year;
s can be determined from the time preference of the representative consumer, who has income (y1, y2)

45. The “AK model” (2)
The utility function of the representative consumer is:
where c is consumption and ρ is the discount rate;
diminishing marginal utility;
the greater the discount rate, the more the consumer prefers present to future consumption
What the consumer saves in period 1, consumes in period 2, for that is the end-period
Capital is not consumable and no borrowing from abroad → s ≥ 0

46. The “AK model” (3)
Savings are given by the surplus of present income over present consumption:
Consumption in the second period:
Substituting the expression of c1 and c2 into the utility function gives:

47. The “AK model” (5) The consumer maximizes utility by choosing s:
Substituting the expression of s into the expression of g gives:
thriftier population will generate faster economic growth;
the growth rate is independent of the initial level of capital

48. The “AK model” (6)
Government policies that reduce the incentive to save, also reduce growth
Government imposes a tax τ on income that finances government consumption (transfer payments):
is the government’s budget constraint
Government transfer t is exogenous to the individual consumer, for she gets T/total population

49. The “AK model” (7)
The consumer’s incentive to save is reduced, for she gets only (1 – τ) of the return of her initial investment
The consumer’s present income and present consumption are exogenous, hence:
and

50. The “AK model” (8) The consumer’s utility function has the form of:
The first order condition of utility maximum is:

51. The “AK model” (9)
Substituting s into the expression of the rate of growth we get:
The higher the tax rate, the lower the rate of growth will be

52. Investment in Computers and Software, 1960 - 2001
Chapter 22: Saving and Capital Formation

53. Saving, Investment, and Financial Markets
Supply of Savings (S)
The quantity supplied of saving is directly related to the real interest rate (r)
Demand for Savings (I)
The quantity demanded for saving is inversely related to r.
Chapter 22: Saving and Capital Formation

54. Saving, Investment, and Financial Markets
Market for Savings
The market will determine the equilibrium (r).
If r is above equilibrium, a surplus of savings will exist.
If r is below equilibrium, a shortage of savings will exist.
Chapter 22: Saving and Capital Formation

55. The Supply and Demand For Savings
Investment I
Savings S
S, I r
Real interest rate (%)
Saving and investment
Chapter 22: Saving and Capital Formation

56. The Effect of a New Technology on National Savings and Investmentr’ F
New Technology
Raises the marginal productivity of capital
This increases the demand for capital S
Real interest rate (%) E r I
Saving and investment
Chapter 22: Saving and Capital Formation

57. Chapter 22: Saving and Capital Formation
The Effects of An Increase in the Government Budget Deficit On National Savings and Investment r’ F S’
Increases in the government budget deficit:
Reduces S public and national saving
r will increase
S & I will fall S E
Real interest rate (%) r I
Saving and investment
Chapter 22: Saving and Capital Formation

58. Gov’t Debt per GDP in Advanced Countries, 2010-16
2011
2012
2013
2014
2015
2016
Australia
29.34
30.72
40.11
38.26
42.44
47.17
51.36
Canada
52.27
53.01
54.78
51.72
50.34
54.71
57.13
Germany
54.33
53.94
55.61
52.68
53.53
50.47
49.24
India
52.18
51.56
50.68
50.31
50.22
49.93
48.59
Japan
161.60
177.49
185.12
187.42
193.43
197.95
199.25
Korea, Rep.
32.87
32.26
33.88
36.67
38.39
39.74
40.27
United Kingdom
83.41
97.17
101.52
97.51
108.60
107.63
106.12
United States
85.60
90.18
94.40
96.61
97.11
97.84
98.21
Mean
68.95
73.29
77.01
76.40
79.26
80.68
81.27
Variance
42.62
48.50
49.94
50.80
52.89
53.59
53.55
STD
6.53
6.96
7.07
7.13
7.27
7.32
Source: WDI 2017
Chapter 22: Saving and Capital Formation

59. Savings, Investment, and Financial Markets
Crowding Out
The tendency of increased government deficits to reduce investment spending
Chapter 22: Saving and Capital Formation