Frank & Bernanke Ch. 10: Saving and Capital Formation

What Is Saving? Saving at the household level is the amount of current income that is not currently consumed. – Joan has an income of $1000 this month. – She buys food for $300, pays rent for $250, buys clothes, entertainment, transportation, education for $300, contributes to a Christmas Club $30, buys $50 of her company’s stock, and adds $50 to her checking account and pays $20 she owes to Jim. – What is her saving?

What Is Saving? Saving at the household level is the amount of income that is added to wealth. – Wealth is the net worth of individuals or households or firms. – Net worth is defined as the difference between assets one owns minus liabilities one owes. – Why would Joan’s $150 in savings increase her wealth?

Net Worth For Joan, her net worth is the difference between her assets and her liabilities. Her net worth is a combination of both real and financial assets. Because Joan may experience both capital gains and capital losses, even if she has zero savings, her net worth may change.

Saving At the National Level The portion of income not spent on consumption but spent on acquiring wealth by households, firms and governments will constitute the national saving. If no part of national saving is used to acquire wealth abroad and no foreigner acquired assets here, then national savings will have to equal to capital formation.

What Is Capital Formation? Net additions to the stock of capital is capital formation. At the household level, additions to net worth (savings) is “capital formation.” At the national level, all the assets minus liabilities will constitute net worth and additions to assets or reductions from liabilities will increase net worth.

What Is Capital Formation? Another name for capital formation is “investment.” We basically seem to say that “savings” and “investments” are the same. However, we want to emphasize that investments are additions to capital stock, buildings, roads, infrastructure, machines, tools. Savings are primarily financial (except homes).

Home Example You buy a home that is built this year. You have $15,000 saved in bank accounts, stocks and bonds which you use for down payment. You borrow the remaining $85,000 from Bank. The market value of the home remains at $100,000. Assuming that your net worth was $15,000 before you bought the house, what is it now?

Home Example The Bank had no assets and 85 people deposited $1000 each - liabilities of $85K and cash (assets) of $85K. The sum of net worth for depositors is $85K. The Bank loaned you the money so it has a piece of paper that says you owe it $85K. Its assets and liabilities are equal. The savings of the 85 people plus your $15K bought the new house.

Home Example The financial savings of $100,000 is used to buy a new home. The new home is an investment worth $100,000. It increases the capital stock of the nation. You own 15% of the home and the savers own 85%. Without the existence of savings, the investments couldn’t have been financed.

Savings and Investment The importance of saving and investment is the ability to convert the financial wealth into capital stock. The more the capital of a country, the higher is the average labor productivity. The higher the average labor productivity, the higher is the standard of living.

Real Interest Rates Real interest rates will play a pivotal role in affecting the decisions of 85 savers, your readiness to borrow the $85,000 and the bank’s willingness to lend the money. There are many reasons why people save and why people invest; but real interest rates appear as one of these reasons in both cases.

Answers to Problem 1, p. 256

Answers to Problem 2, p. 256

Why Do People Save? 1. Demonstration effect will lower the saving rate. 2. They would have more need for precautionary saving. Also, they might be more frugal, hoping to save more for retirement because they don’t have the confidence of social security. They might also want to bequeath more to their children because they don’t trust the future. (Precautionary Saving; Life-cycle Saving; Bequest Saving) 3. As more people retire compared to people in the work force, additions to savings will be less than withdrawals from savings resulting in a decrease in savings.

Life-Cycle Saving College fund Marriage planning Expecting baby Saving for travel Saving for home

Why Do People Save? Payroll deductions for Christmas Clubs, retirement pension funds might increase savings by eliminating the temptation to spend the available income. Easy terms to borrow (high limits on credit cards, home equity loans) might increase the spending and reduce savings. Higher real interest rates might convince people to save more. Capital gains might reduce savings; capital losses might increase savings.

National Saving Y = C + I + G + NX Assume for now that NX=0. Y or GDP is also the incomes earned by households (remember the circular flow?) Y = C + T + S C + T + S = C + I + G

National Saving (T - G) + S = I Government Saving + Private Saving = Investment Investments (increasing the capital stock) is financed by national saving. National Saving, therefore is the sum of Public Saving and Private Saving. (T - G) + S = I = Y - C - G

Gross Saving

Gross Saving Capital consumption (depreciation) is keeping up and repairing buildings and equipment. It is part of investment directly paid by savings. Net foreign investment is the trade deficit which we will discuss later. For now, realize that Y=C+G+I+NX and Y=C+S+T would combine to give S+(T+G)=I+NX, i.e., trade balance shows up on the investment side in the previous slide. Statistical discrepancy is to indicate that I=S but because data is collected from different sources it doesn’t match.

Savings Rates Years Gross Saving Personal Saving Government Saving Business Saving %6.18%-1.38%12.10% %6.53%-2.48%11.85% %5.27%-1.80%12.14% %4.45%-0.61%12.46% %4.06%-0.11%12.95% %3.47%0.75%12.98% %3.03%1.90%13.07% %3.44%3.11%12.25% %1.73%3.87%12.79% %0.69%4.69%12.72% %2.00%1.45%13.05% %3.22%-0.65%11.53% %2.76%-1.36%12.10%

Low Household Savings By international standards, personal savings in the US are low and getting even lower. Since it is national savings that matter for investments, high business saving and increasing government saving eliminate the low personal saving. Increase in wealth might be the reason for decreasing household saving. Low savings and negative wealth for the poor households is a major concern.

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Investment and Capital Formation The importance of national saving is that it finances investment. Investment is capital formation. Capital formation increases the physical capital in a country, raising average labor productivity.

Factors That Affect Investment Price of capital goods: lower price, more investment. Real interest rate: lower real interest rate, more investment. Technological advancement that increases the marginal product of capital. Lower taxes on the revenues generated by capital. A higher relative price for the firm’s output.

Problem 7, p. 257 Ellie and Vince are trying to decide whether to purchase a new home. The house they want is priced at $200,000. Annual expenses such as maintenance, taxes, and insurance equal 4% of the home’s value. If properly maintained, the house’s real value is not expected to change. The real interest rate is 6%. They pay no down-payment and ignore mortgage tax-deduction. (a)If they are willing to pay $1500 monthly rent for a similar house, should they buy the house? (b)What if they were willing to pay $2000? (c)What if the real interest rate were 4%? (d)What if the price of the house were $150,000? (e)Why do home-building companies dislike high interest rates? (a)No. (b)Yes. (c)Yes. (d)Yes.

Savings and Investments People save to accumulate wealth. People save for life-cycle reasons. People save for precautionary reasons. People save for bequeathing. People save in response to high real interest rates. People invest when the price of capital goods fall. When the marginal product of capital increases due to technology. When the relative price of the output rises. When taxes on revenue generated are lowered. When real interest rates are low.

Financial Markets Real interest rate Saving and investment S I Savings are funds to be lent. Savers are also lenders. Investors are borrowers. Ceteris paribus, they both respond to real interest rates. What happens when r is not at equilibrium?

Shifts What happens when stock market falls? What happens when war breaks out? What happens when a new child is born to the family? What happens when the government budget moves from surplus to deficit? What happens when new legislation is passed that increases Social Security payments in the future? What happens when “baby boom” generation reaches working age? What happens when “baby boom” generation reaches retirement?

Shifts What happens when price of computing power drops by 50%? What happens a new software increases the output of a computer? What happens when the designs created by using a computer/software are much in demand – higher in price? What happens when the government puts an extra tax on mobile phones?