Savings and Investment Process Chapter 7 Savings and Investment Process © 2011 John Wiley and Sons

Gross Domestic Product (GDP) and Capital Formation Gross Domestic Product: Measures the output of goods and services in an economy over a specified time period Capital Formation: Process of constructing real property, manufacturing producers’ durable equipment, and increasing business inventories

Gross Domestic Product (GDP) Components GDP is composed of: Personal Consumption Expenditures Government Expenditures including Gross Investment Gross Private Domestic Investment Net Exports of Goods and Services

Gross Domestic Product (GDP) Components (continued) Equation: GDP = PCE + GE + GPDI + NE Personal Consumption Expenditures (PCE): Expenditures by individuals for durable goods, nondurable goods, and services Government Expenditures (GE): Purchases of goods and services by the government

Gross Domestic Product (GDP) Components (continued) Equation: GDP = PCE + GE + GPDI + NE Gross Private Domestic Investments (GPDI): Investments in residential & nonresidential structures, producers’ durable equipment, & business inventories Net Exports (NE): Exports minus imports of goods & services

Recent Gross Domestic Product (GDP) Amounts ($ Billions) 2006 2009 GDP $13,253.9 $14,258.7 PCE 9,270.8 10,092.6 GPDI 2,218.4 1,622.9 NE -761.8 -390.1 GE 2,526.4 2,933.3

Link Between Saving and Investment Gross Saving = Net Saving + Consumption of Fixed Capital For 2008 (in $ Billions): Net Saving = -$23.0 Consumption of Fixed Capital = $1,847.1 Gross Saving = $1,824.1

Link Between Saving and Investment Net Saving = Net Private Saving + Net Government Saving For 2008 (in $ Billions): Net Private Saving = $659.8 Net Government Saving = -$682.7 Net Saving (rounded) = -$23.0

Link Between Saving and Investment Consumption of Fixed Capital = Private + Government For 2008 (in $ Billions): Private = $1,536.2 Government = $310.9 Consumption of Fixed Capital = $1,847.1

Federal Government Receipts and Expenditures 1970-1997: Annual deficit budgets 1998-2001: Annual surplus budgets 2002-Present: Annual deficits with fiscal 2009 and 2010 deficits each exceeding $1.0 trillion [National Debt now exceeds $12 trillion]

Federal Government Dollar: Fiscal Year 2008 Where It Comes From (Income): --Personal Income Taxes (39%) --Social Security and other Retirement Taxes (30%) --Borrowing to Cover Deficit (15%) --Corporate Income Taxes (10%) --Excise, Estate, and other Taxes (6%)

Federal Government Dollar: Fiscal Year 2008 (continued) Where It Goes (Outlays): --Social Security, Medicare, and other retirement (37%) --National Defense, veterans, and Foreign Affairs (24%) --Social Programs (including Medicaid)(20%) --Physical , Human, and Community Development (9%) --Net Interest on the Debt (8%) --Law Enforcement and General Gov’t. (2%)

Debt Financing Budgetary Deficit: Occurs when expenditures are greater than revenues Federal Statutory Debt Limits: Limits on the federal debt set by Congress

Historical Role of Savings in the United States Foreign investors initially purchased large amounts of the securities sold by government & private promoters to develop the U.S. The American family later took over the function of providing savings for the capital formation process

Creation of Savings Savings: Income that is not consumed but held in the form of cash and other financial assets Savings Surplus: Occurs when current income exceeds investment in real assets

Creation of Savings Savings Deficit: Occurs when investment in real assets exceeds current income Undistributed Profits: Proportion of after-tax profits retained by corporations

Major Sources of Savings Personal Saving: Savings of individuals equal to personal income less personal current taxes less personal outlays Voluntary Savings: Savings held or set aside by choice for future use Contractual Savings: Savings accumulated on a regular schedule by prior agreement

Personal Savings in the U.S. Personal Savings Definition: Personal income Less: taxes and other payments Equals: disposable personal income Less: personal outlays Equals: personal savings Savings Rate Definition: Savings Rate = (Personal Savings)/ (Disposable Personal Income)

Historical Personal Savings Rates 1960 5.8% 1965 7.0 1970 8.1 1975 9.2 1980 7.1 1985 4.5 1990 4.3 1995 4.8 2000 1.0 2005 1.4

Corporate Savings in the U.S. Undistributed Profits Definition: Profits before taxes Less: tax liabilities Equals: profits after taxes Less: dividends Equals: undistributed profits Retention Rate Definition: Retention Rate = (Undistributed Profits)/(Profits After Taxes)

Corporate Savings in the U.S. Adjustments to Corporate Profits: Nonfinancial corporate profits before taxes are often shown after (1) inventory valuation and (2) capital consumption adjustments (1) Records estimated changes in inventory values over time (2) Reflects the “using up,” or depreciation, of plant and equipment assets used for business purposes

Factors Affecting Savings Levels of income Economic expectations Cyclical Influences (economic cycles) Life stage of the individual saver or corporation

Life Stages of the Individual Saver --Formative/education developing --Career starting/family creating --Wealth building --Retirement enjoying

Life Stages of the Corporation --Start-up stage --Survival stage --Rapid growth stage --Maturity stage

Capital Market Securities Markets where debt securities with maturities longer than one year and corporate stocks are issued or traded Capital Market Securities: Debt securities with maturities longer than one year and corporate stocks

Major Capital Market Securities Securities: Issuers: Mortgages Fin. intermediaries Treasury bonds U.S. government Municipal bonds State/local gov’ts. Corporate bonds Corporations Corporate stocks Corporations

Major Capital Market Securities Securities: Secondary Market: Mortgages High activity Treasury bonds High activity Municipal bonds Moderate activity Corporate bonds Moderate activity Corporate stocks High activity

Capital Market Securities Defined Mortgage: Loan backed by real property in the form of buildings and houses Treasury bond: Long-term debt instrument issued by the U.S. federal government Municipal bond: Long-term debt instrument issued by a state or local government

Capital Market Securities Defined Corporate bond: Debt instrument issued by a corporation to raise long-term funds Common stock: Ownership interest in a corporation

Derivative Security Derivative Security: Financial contract that derives its value from a bond, stock, or other asset Use of Derivative Securities: Corporations can use derivative securities to insure or hedge against various financial risks