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

©2012 The McGraw-Hill Companies, All Rights Reserved

1

Chapter 18: Saving, Capital Formation, and

Financial Markets


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 save4. Discuss the reasons firms choose to

invest in capital rather than financial assets

5. Analyze financial markets using the tools of supply and demand


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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.)


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Maria’s Balance Sheet, 1/1/2011

Assets LiabilitiesCash $80 Student loan $3,000Checking account 1,200 Credit card

balance250

Shares of stock 1,000Car (market value) 3,500Furniture (market value)

500

Total $6,280 $3,250Net worth $3,030


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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


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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


7

Maria’s Balance Sheet, 2/1/2011

Assets LiabilitiesCash $80 Student loan $3,000Checking account 1,200 Credit card

balance250

Shares of stock 1,500Car (market value) 3,500Furniture (market value)

500

Total $6,780 $3,250Net worth $3,530


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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


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Calculate National Savings

Assume NX = 0 for simplicityNational 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 needsS = Y – C – G


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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.


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Private Saving

Private saving is household plus businesses saving

Household's total income is YHouseholds 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


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Private Saving

Private saving is after-tax income less consumption

SPRIVATE = Y – T – CPrivate 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


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

SPUBLIC = T – G

National saving (S) is private savings plus public savings

SPRIVATE + SPUBLIC = (Y – T – C) + (T – G)S = Y – C – G


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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


15

Government Receipts and Expenditures (in billions of local

currency) 2009 2010

Country Receipts Expenditures

Difference

Receipts

Expenditures

Difference

Algeria 3,672 4,214 -542 4,592 5,779 -1,187Bahrain 1.75 2.43 -0.69 2.08 2.52 -0.44Egypt 289 361 -72 300 398 -98Iran 829,930 884,798 -54,868 965,95

9952,059 13,900

Iraq 59,905 76,799 -16,894 74,782 88,741 -13,959Jordan 4.47 5.91 -1.44 4.49 5.65 -1.16Kuwait 19 13 6 20 15 5

Lebanon 12,802 17,030 -4,228 14,224 19,333 -5,109Libya 49 42 7 58 45 13

Morocco 194 213 -19 191 217 -26Oman 7.22 6.87 0.35 9.12 7.73 1.39Qatar 155 102 53 169 114 55Saudi Arabia

594 628 -34 727 696 31

Sudan 20 26 -6 27 33 -6Syria 534 667 -133 593 713 -120

Tunisia 17.24 18.11 -0.87 18.46 20.18 -1.73UAE 212 264 -52 263 249 14

Yemen 1,275 1,795 -520 1,836 2,210 -374


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Three Components of Egyptian National Savings, 1996 – 2008


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Three Components of Moroccan National Savings, 1996 – 2007


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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


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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


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


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 incomeThrifts’ income grows

faster From 1995 on, Thrifts

consume more than Spends

Spends ThriftsSavings Rage 5% 20%

Start Date 1980 1980End Date 2015 2015Real Income $40,000 $40,00

0Real Interest 8% 8%


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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


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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


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


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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 elsewhereCost – Benefit Principle indicates

whether Harith should start the business


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Harith and the Lawn Mower

Business plan analysis

Net revenue $6,000Less taxes (20%) $1,200Less opportunity cost $4,400Equals VMP of lawnmower $400Less interest (6%) $240Equals net benefit $160

Harith should start the business


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The Investment Decision

Two important costs Price of the capital goods Real interest rates

Opportunity cost of the investmentValue 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


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Investment in Computers, 1960 - 2007

Computer technology may have driven increases in productivity since 1995


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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


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

increasesDemand for investment (I) is the

amount of savings borrowed at each possible real interest rate The quantity demanded is inversely

related to r


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

Rea

l int

eres

t rat

e (%

)

Investment I

Saving S

S, I

r


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


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 investmentSaving and Investment

Rea

l int

eres

t rat

e (%

)

I

rE

S

r'

I'

F

A'

A


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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

Rea

l int

eres

t rat

e (%

) S

rEr'

F

S'

AA'


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

incomeHigher national saving rate leads to

greater investment in new capital goods and a higher standard of living

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

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