Saving and Capital Formation

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

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

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

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

Consuelo’s Balance Sheet Assets Cash $ 80 Checking account 1,200 Shares of stock 1,000 Car (market value) 3,500 Furniture (market value) 500 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

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

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

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

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) 500 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

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 2000 - 2001 the fall in stock prices was offset by rising home values Chapter 22: Saving and Capital Formation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

National Saving and Its Components Public Saving and the Government Budget 2000 Spublic= T - G Federal: 218.5 = 2,046.8 - 1,828.3 State & local: 32.8 = 1,222.6 - 1,189.8 Spublic = 251.3 = 3,269.4 - 2,018.1 Chapter 22: Saving and Capital Formation

National Saving and Its Components Public Saving and the Government Budget 1995 Spublic= T - G Federal: -174.4 = 1,460.3 - 1,634.7 State & local: 111.7 = 997.7 - 886.0 Spublic = -62.7 = 2,458.0 - 2520.7 Chapter 22: Saving and Capital Formation

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

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

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

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

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

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

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

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

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

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

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

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)

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

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:

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

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

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

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

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

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

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

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

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

The Effect of a New Technology on National Savings and Investment r’ 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

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

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

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