1. 8
CAPITAL, INVESTMENT, AND SAVING
CHAPTER

2. Objectives After studying this chapter, you will able to
Describe the growth and fluctuations of investment and the capital stock and the real interest rate
Explain how business investment decisions are made
Explain how household saving decisions are made
Explain how investment and saving interact to determine the real interest rate
This chapter makes extensive use of the demand and supply model of Chapter 3 and applies it to the global market for financial capital. “Demand” in this market is investment demand, “supply” is saving supply, and “price” is the real interest rate, which is both the return to saving and the opportunity cost of investment. Once the student understands these parallels with the basic demand and supply analysis, the mechanics of this chapter will be relatively straightforward.

3. Objectives After studying this chapter, you will able to
Explain how government influences the real interest rate, saving, and investment
Explain what determines international borrowing and lending

4. Illusion or Real?
In 1999, a stock market boom increased wealth by four times the amount of saving measured by the national income accounts.
Which is the true measure of saving?
Saving finances investment in new capital, which increases labor productivity.
How do firms make investment decisions and households make saving decisions, and how do capital markets coordinate the two?

5. Capital and Interest Investment and Capital
The capital stock is the total amount of plant, equipment, buildings, and inventories, or physical capital.
Gross investment is the purchase of new capital.
Depreciation is the wearing out of the capital stock.
Net investment equals gross investment minus depreciation, and net investment is the addition to the capital stock.
Definitions and the meaning of investment in economics. The student has met the key definitions of this section in Chapter 19, but to be absolutely sure that they are remembered, this chapter repeats them. It is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.

6. Capital and Interest
Figure 8.1(a) shows gross investment and depreciation for the period 1981–2001.
The amount of gross and net investment decreases during recessions and increases during expansions.

7. Capital and Interest
Figure 8.1(b) shows net investment and the capital stock for the period 1981–2001.
The capital stock has increased every year since 1981 by an amount that fluctuated between $0.3 trillion and $0.7 trillion per year.

8. Capital and Interest Saving
Saving is current income minus current expenditure, and in part finances investment.
Personal saving is personal disposable income minus consumption expenditure.
Business saving is retained profits and additions to pension funds by businesses.
Government saving is the government’s budget surplus.
Any of these components can be negative.
The U.S. saving rate. The low U.S. saving rate, described in this chapter, is very interesting to students. They are also intrigued by the low level of personal saving and the high level of business saving. It is worth emphasizing that part of the reason for the low personal saving rate is that payroll deductions for employment pension plans are business savings.

9. Capital and Interest
Figure 8.2 shows the three components and the total for 1981–2001.

10. Capital and Interest
Figure 8.3 shows investment minus saving, the saving gap, for the United States over 1981–2001, illustrating how the gap is near zero in recessions but otherwise positive, and grew during the 1990s.

11. Capital and Interest Interest Rates
The return on capital is the real interest rate, which (approximately) equals the nominal interest rate minus the inflation rate.
Figure 8.4 shows the real interest rate from 1981 to 2001, which fluctuates around an average close to 6 percent a year.
Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, you might like to use the example of a 30-year fixed rate mortgage. Get the students to use the past 10-year average as a guide to the rate of increase in housing prices, and calculate the real interest rate on a 30-year fixed rate mortgage. The student can get a quote for a 30-year fixed rate mortgage at (this link is on the Economics Place Web site) and can find the price increases in your own region at (also on the Economics Place Web site).

12. Investment Decisions Business investment decisions are influenced by
The expected profit rate
The real interest rate
Confusing saving and investment. Some of your students will confuse saving and investment. And this confusion will lead them to be puzzled by the slope of the investment demand curve. You can help all your students avoid this confusion by hitting it head on. Ask them the following question: “If the interest rate rises, I’m going to put more money in my savings account, stock market, or whatever. So why do we say that a higher interest rate decreases investment?” In the ensuing discussion, get the students to see that placing funds in a savings account, stock market, or whatever, is saving, which does increase if the interest rate rises (other things remaining the same). Remind them that investment demand refers to the demand by firms (and households) for physical capital goods. By explicitly tackling this source of confusion, you can simultaneously explain why investment and saving respond in opposite directions to a change in the interest rate.

13. Investment Decisions The Expected Profit Rate
The expected profit rate is relatively high during business cycle expansions and relatively low during recessions.
Advances in technology can increase the expected profit rate.
Taxes affect the expected profit rate because firms are concerned about after-tax profits.

14. Investment Decisions The Real Interest Rate
The real interest rate is the opportunity cost of the funds used to finance investment.
Regardless of whether a firm borrows or uses its own financial resources, it faces this opportunity cost.
Either it pays the interest or it forgoes interest on its own funds.

15. Investment Decisions Project Funds needed Expected profit rate 1
$200,000 25 2 15 3 10 4 7 5 6
Why the interest rate is the opportunity cost of making an investment
An explicit numerical example can help to make this idea clear.
Scenario 1: The firm has no funds but can borrow any amount it chooses at an interest rate of 8 percent a year. It can use the funds to invest in any or all of seven projects that have expected profit rates shown in the table. (The interest component of cost has not been counted in calculating the expected profit rate—that is, the expected profit rate is before paying interest.)
Ask your class to say what the firm does.
Get the students to figure out and explain why the firm borrows $600,000 and invests in projects 1, 2, and 3. It earns an expected profit of 17 percent on project 1, 7 percent on project 2, and 2 percent on project 3.
[To use this slide and the next one in your classroom, click Slide Show, Hide Slide]

16. Investment Decisions Project Funds needed Expected profit rate 1
$200,000 25 2 15 3 10 3A
Any amount (+/-) 8 4 7 5 6
Scenario 2: Everything is the same as in Scenario 1 except that the firm has $1,400,000, which it can use to invest in any or all of seven projects that have expected profit rates shown in the table.
Again, ask your class to say what the firm does.
Get the students to figure out and explain why the firm uses $600,000 of its funds to invest in projects 1, 2, and 3.
If necessary, modify the table as shown on this slide to get them to see that the firm can earn 8 percent by lending the remaining $800,000 to other firms.

17. Investment Decisions Investment Demand
Investment demand is the relationship between the level of planned investment and the real interest rate.
Figure 8.5 illustrates an investment demand curve.

18. Investment Decisions The investment demand curve slopes downward.
A fall in the real interest rate increases planned investment along the investment demand curve.
A rise in the real interest rate decreases planned investment along the investment demand curve.

19. Investment Decisions
Figure 8.5(b) illustrates a change in investment demand.
If the expected profit rate increases, the investment demand curve shifts rightward from ID0 to ID1.
If the expected profit rate decreases, the investment demand curve shifts leftward from ID0 to ID2.

20. Investment Decisions Investment Demand in the United States
Figure 8.6 interprets investment demand in the United States between 1981 and 2001.
Movements along an investment demand curve show changes in the quantity of investment that result from changes in the real interest rate.

21. Investment Decisions
Shifts of the investment demand curve show changes in investment demand that result from changes in the expected profit rate.

22. Saving Decisions
Investment is financed by national saving and borrowing from the rest of the world.
National saving is the sum of private saving and government saving.
Households divide their disposable income between consumption expenditure and saving.

23. Saving Decisions Saving is influenced by The real interest rate
Disposable income
Wealth
Expected future income

24. Saving Decisions Real Interest Rate
The higher the real interest rate, the greater is a household’s opportunity cost of consumption and so the larger is the amount of saving.
Disposable Income
The higher the disposable income, the greater is a household’s saving.
The book is very clear on why the real interest rate, disposable income, wealth, and expected future income should all influence saving and how. A potential problem is that brighter students who have fully understood substitution and income effects will see that an increase in the real interest rate raises the opportunity cost of consumption now, but also raises current and expected future disposable income for those with net financial assets, so the overall impact on saving is theoretically ambiguous. The best response is probably to simply assert that empirically we have reason to believe that, in the United States at least, the substitution effect outweighs the income effect and the saving supply schedule can be confidently presumed to be upward sloping, although perhaps fairly inelastic – as Figure 8.8 suggests.

25. Saving Decisions Wealth
The greater is a household’s wealth, other things remaining the same, the greater is its consumption and the less is its saving.
Expected Future Income
The higher a household’s expected future income, the greater is its current consumption and the lower is its current saving.

26. Saving Decisions Saving Supply
Saving supply is the relationship between saving and the real interest rate, other things remaining the same.
Figure 8.7(a) shows a saving supply curve, which slopes upward.

27. Saving Decisions A fall in the real interest rate decreases saving.
A rise in the real interest rate increases saving.

28. Saving Decisions
Figure 8.7(b) shows the effect of a change in any other influence on saving, which changes saving supply and shifts the saving supply curve.

29. Saving Decisions Saving Supply in the United States
Figure 8.8 illustrates saving supply in the United States from 1981 to 2001.
The U.S. saving supply curve has tended to shift rightward, except in recessions, because of growth in disposable income.

30. Equilibrium in the World Economy
The real interest rate is determined in the global market because capital can readily move from one country to another; that is, one nation’s saving can finance another country’s investment.
On the average. It is worth emphasizing that this section explains how the world average real interest rate gets determined. Sure, there are lots of different interest rates even inside the United States, and many more around the world. Interest rates differ mainly because different loans have different degrees of risk attached. Many people fail to pay their credit card balance, so the risk that banks take lending on credit cards is large and the interest rate is high. In contrast, almost everyone repays their home loan on time, so the risk that banks take lending on home mortgages is small and the interest rate is low. Loans made in different countries also have different degrees of risk. It is less risky to lend to the U.S. government than to the Argentine government, for example. So risk differences create differences in real interest rates. But interest rates move up and down together in response to forces that determine the average interest rate. These are the forces that we’re studying in this section. (The interest rate used in the text is selected as a broad representative long-term rate and is Moody’s AAA.)
Arbitrage. The chapter explains arbitrage (not by name) briefly. You might want to do a bit more and tell your students that arbitrage equalizes (risk adjusted) interest rates around the world. (Note that $1.5 trillion crosses the foreign exchange markets on a typical day in 2002.)
The real interest rate doesn’t have a trend. It is worth emphasizing that unlike the real wage rate, which rises over time, the real interest rate does not rise. Rather, it keeps returning to its long-term average level. The reason is that both investment demand and saving supply increase over time and, on the average, over long periods by roughly the same amounts. Occasionally, as occurred during the early 1980s, investment and saving might change by very different amounts and bring a big swing in the real interest rate.

31. Equilibrium in the World Economy
Determining the Real Interest Rate
The real interest rate is determined by the world investment demand and world supply of savings.
In Figure 8.9, ID is the world investment demand curve.
SS is the world supply of saving curve.

32. Equilibrium in the World Economy
The equilibrium real interest rate is 6 percent.
At the equilibrium real interest rate, there is neither a shortage nor surplus of saving.

33. Equilibrium in the World Economy
Explaining Changes in the Real Interest Rate
Figure 8.10 on the next slides shows how investment demand and saving supply in the world economy brought real interest rate fluctuations.

34. Equilibrium in the World Economy
From 1981 to 1984, an increase in the expected profit rate helped by a recovery from a U.S recession increased world investment demand.
By 1984 the investment demand curve was ID84 and the real interest rate reached a peak of almost 9 percent a year.

35. Equilibrium in the World Economy
After 1984 saving supply increased by more than investment demand and the real interest rate fell.
After 1991, saving supply and investment demand increased at similar rates, so the real interest rate did not change much.

36. The Role of Government Government saving is part of total saving.
Because funds flow between countries and the real interest rate is determined in the world market, it is the aggregate saving of all governments throughout the world that matters.
In total, government is large; worldwide, government saving is negative (governments have a deficit) at about 10 percent of total saving.

37. The Role of Government Government Budgets
Although each country has imports and exports, when we sum over all countries to obtain world totals, exports and imports are zero.
World GDP = C + I + G.
Also, world GDP = C + S + T.
From these two equations, you can see that for the world as a whole I = S + T – G.
The national income accounting identities. It is worth refreshing the student’s memory about the national income accounting identities used here. First, point out that although each nation has exports and imports, the world as a whole doesn’t. To drive home the point, you might note that in the world of Star Wars, the Earth has exports and imports with other parts of the galaxy, but we’re not there yet! Second, remind the students that the expenditure that equals GDP is the sum of consumption expenditure, investment, and government purchases. Third, remind them that GDP equals income, and income is either consumed, saved, or paid in taxes. You’re now only a step away from showing why investment is financed by private saving (S = Y – C – T) plus the government sector budget surplus (T – G), that is I = S + (T – G).

38. The Role of Government
If net taxes exceed government purchases, T > G, the government has a budget surplus and government saving is positive.
If net taxes are less than government purchases, T < G, the government budget is in deficit and government saving is negative.

39. The Role of Government Direct Effect of Government Saving
Government saving is part of total saving.
The direct effect of a government budget deficit is a decrease in total saving.
When total saving decreases, the real interest rate rises and the equilibrium quantity of investment decreases.
The tendency of a government budget deficit to decrease investment is called a crowding-out effect.

40. The Role of Government
Figure 8.11 illustrates the crowding-out effect of an increase in the government budget deficit.

41. The Role of Government Indirect Effect of Government Saving
A government budget deficit also has an indirect effect that offsets the direct effect.
The Ricardo-Barro effect is an increase in private saving by an amount equal to the government budget deficit.
This effect occurs if households recognize that a government budget deficit must be paid for by higher taxes in the future.

42. The Role of Government
If the Ricardo-Barro effect operates, a government budget deficit has no effect on the real interest rate and hence does not decrease the quantity of investment.
Figure 8.12 illustrates the Ricardo-Barro effect.
The Ricardo-Barro effect. The Ricardo-Barro effect is hard for students to accept. Explain first that not even a $1s worth of Ricardo-Barro effect would occur if people had no foresight or if we were all going to die at the end of the current period. Then explain that the full effect would occur only if people had perfect foresight and lived for ever. Now point out that both of these situations are extremes and that reality lies between the two. A partial Ricardo-Barro effect means that some crowding occurs but the effect is smaller than that shown in Figure Crowding out is not eliminated as shown in Figure 8.12.

43. The Role of Government
Reality probably lies between total crowding out and a complete Ricardo-Barro effect.
That is, an increase in the global government budget deficit crowds out some investment and raises the real interest rate.

44. The Role of Government Government Deficits Today
Figure 8.13 shows estimates of total government surplus and deficit for the advanced economies over 1983–2001, as a percentage of GDP.

45. Saving and Investment in the National Economy
The world real interest rate determines the quantity of a nation’s saving and investment.
If, at the world real interest rate, the quantity of a nation’s investment exceeds that of its saving, the country borrows from the rest of the world.
If, at the world real interest rate, the quantity of a nation’s investment is less than that of its saving, the country lends to the rest of the world.

46. Saving and Investment in the National Economy
Figure 8.14 illustrates the case of a nation that borrows from the rest of the world.

47. Saving and Investment in the National Economy
When a nation borrows from the rest of the world, its net exports are negative—it imports more than it exports.
When a nation lends to the rest of the world, its net exports are positive—it exports more than it imports.
International Borrowing and Lending in the World Today
For the past 20 years, the United States has been a borrower and Japan has been a lender.
International deficit not a sign of inability to compete
It is worth spending a few minutes on this topic. The chapter explains what determines the scale of international borrowing and lending and points out that net exports are determined by the same forces.
You have a good opportunity here to point out that a foreign trade deficit (negative net exports) doesn’t mean that the nation is uncompetitive. Rather, it means that the nation invests more than it saves.
This example provides an opportunity to reinforce a fundamental feature of the economic way of thinking and is an example of what Jagdish Bhagwati is talking about in the last part of my interview with him on page 485.

48. Saving and Investment in the National Economy
Government Deficit and International Borrowing
An increase in the government deficit decreases the nation’s total saving and increases international borrowing.
U.S. net exports have been negative for the past 20 years because national saving has been less than investment.
The government budget deficit in past years has helped decrease national saving and has contributed to international borrowing.

49. Saving and Investment in the National Economy
Because it is the world real interest rate that determines investment, a U.S. government budget deficit has a smaller effect on U.S. interest rates, and smaller crowding-out effect, than often popularly believed.

50. 8
CAPITAL, INVESTMENT, AND SAVING
CHAPTER
THE END