Lecture Principles of economics (Asia Global Edition) - Chapter 19

After studying this chapter you will be able to: Explain the relationship between savings and wealth, identify and apply the components of national saving, discuss the reasons why people save, discuss the reasons why firms choose to invest in capital rather than financial assets, analyze financial markets using the tools of supply and demand.

Saving, Capital Formation, and

Financial Markets

Chapter 19

3. Discuss the reasons why people save

4. Discuss the reasons why firms choose to invest

in capital rather than financial assets

5. Analyze financial markets using the tools of

supply and demand

Savings and Wealth

• Saving is current income minus spending on

current needs

– The saving rate is saving divided by income

• Wealth is the value of assets minus liabilities

– Assets are anything of value that one owns

– Liabilities are the debts one owes

– The balance sheet is a list of an economic unit’s

assets and liabilities

Individual Balance Sheet, 1/1/14

Checking account 1,200 Credit card balance 250 Shares of stock 1,000

Car (market value) 3,500

Furniture (market value) 500

Net worth $3,030

Flow Values and Stock Values

• A flow value is defined per unit of time

– 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

Capital Gains and Losses

• Wealth changes when the value of your assets change

– Capital gains increase the value of existing assets

– Capital losses decreases the value of existing

US Stock Prices, 1960 - 2004

The Bull Market of the 1990s

• Stock ownership increased

– Direct purchases

– Mutual funds

– Pension and retirement funds

• Stock prices rose rapidly

– Capital gains on stocks increased household wealth

• Stock market declined, 2000 – 2002

– Household savings remained low

– Value of privately-owned homes increased rapidly

National Savings

• Macroeconomics studies total savings in the

economy

– Household savings is one component

– Business and government savings are other parts

• Start with the definition of production and income for the economy

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

current needs

S = Y – C – G

National Saving Ratio (% )

United States Singapore

Private Saving

• Private saving is household plus business saving

• Household's total income is Y

• Households pay taxes (T) from this income

– Government transfer payments increase household income

households without receiving any goods in return

– Interest is paid to government bond holders

T = Taxes – Transfers – Government interest

payments

less dividends to shareholders

equipment

Public Saving and National

Saving

that is not spend on current needs

SPUBLIC = T – G

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

S = Y – C – G

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)

– Government budget deficit is the excess of

government spending over net tax collections

From Surplus to Deficit

• Three reasons for change in U.S government

budget

– Government receipts decreased during the

recessions of 2001 and 2007-2009

– Tax reductions during the first Bush term

– Government spending increased

U.S National Saving, 1960-2010

Low Household Savings

• National savings determines a country's ability to

invest in new capital goods

– Household savings has been low

– Business saving has been significant

– In the 1990s, government saving increased

• From 1960 to 2002, U.S national saving rate

was fairly stable

• Since 2002, U.S government dissaving has

contributed to a decline in the U.S national

saving rate

Three Reasons for Household

Saving

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

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

• Bequest savings matters; precautionary savings is low

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

Thrifts and Spends

• Two otherwise identical families have different

savings rates

• Thrifts consume $32,000 in 1980 and Spends consume

consume more than

Thrifts and Spends

Savings in Perspective

• 8% is lower than the return to mutual funds since 1980

• 20% 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

Maximize Lifetime Well Being

• Psychologists suggest individual self-control may

be too weak to produce rational outcomes

– Smoking, obesity, gambling, and spending

• Devices to support savings

– Make savings automatic and withdrawals costly

• Easy borrowing supports high levels of current

spending

– Credit cards

– Home equity loans

Explaining U.S Household

Savings Rate

• Savings rate may be depressed by

– Social Security, Medicare, and other government

programs for the elderly

– Mortgages with small or no down payment

– Confidence in a prosperous future

– Increasing value of stocks and growing home

values

– Readily available home equity loans

– Demonstration effects and status goods

Investment and Capital

Formation

• Investment is the creation of new capital goods and housing

• Firms buy new capital to increase profits

– Cost is the cost of using the machine or other

capital

– Benefit is the value of the marginal product of the

capital

Larry and the Lawn Mower

• Larry's lawn care business plan

– Cost of lawn mower = $4,000

– Net revenue = $6,000 per summer

working elsewhere

• Cost – Benefit Principle indicates whether Larry

should start the business

Larry and the Lawn Mower

• Business plan analysis

The Investment Decision

• Two important costs

– Price of the capital goods

– Real interest rates

• 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

Investment in Computers

• Purchases of new computers and software is

more than 2.5% of GDP

– 24% of all private nonresidential investment

• Computer investment increased faster than other capital goods

– Unique attributes of computers are

– Computing power per dollar doubles every 18 months

computers

Investment in Computers, 1960-2010

• Computer technology may have driven increases in productivity since 1995

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

g S

S, I r

Financial Markets Are Markets

• Financial markets adjust to surpluses and

shortages as any other market does

• Changes in factors other than real interest rates will shift the savings or investment curves

– New equilibrium

Technological Improvement

• New technology raises marginal productivity of capital

demand for investment funds

savings supply curve

savings and investment

Saving and Investment

Government Budget Deficit

Increases

• Government budget deficit increases

investment curve

F

S'

Increase National Saving

• Policymakers know the benefits of increased

national saving rates

– Reducing government budget deficit would increase national saving

– Increase incentives for households

• Higher national saving rate leads to greater

investment in new capital goods and a higher

standard of living

Saving, Capital Formation, and

Financial Markets

Saving Wealth

Capital Gains

and Losses

National

Private Saving

Public Saving

Government Budget

Low Household Saving

Interest Rate

Investment

and Capital

Financial Markets