MBMC Saving and Capital Formation

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 2 Introduction Motives for Saving To meet future expenditures Protect against an economic emergency Produce capital goods

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 3 Household Saving Rate in the United States, Observations Household saving has fallen dramatically National saving has not declined in recent years

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 4 Savings and Wealth Saving Current income minus spending on current needs Saving Rate Saving divided by income

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 5 Savings and Wealth Wealth The value of assets minus liabilities Assets Anything of value that one owns Liabilities The debts one owes

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 6 Consuelo’s Balance Sheet Assets Cash$ 80 Checking account1,200 Shares of stock1,000 Car (market value)3,500 Furniture (market value) 500 Total $6,280 Liabilities Student loan$3,000 Credit card balance250 ______ $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)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 7 Savings and Wealth Flow A measure that is defined per unit of time Stock A measure that is defined at a point in time

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 8 Savings and Wealth 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 9 Savings and Wealth Stocks and Flows Saving is a flow. Wealth is a stock. Every dollar a person saves adds to their wealth.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 10 Savings and 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 11 Savings and Wealth Capital Gains Increases in the value of existing assets Capital Losses Decreases in the value of existing assets

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 12 Consuelo’s Balance Sheet After An Increase in the Value of Her Stocks Assets Cash$ 80 Checking account1,200 Shares of stock1,500 Car (market value)3,500 Furniture (market value) 500 Total $6,780 Liabilities Student loan$3,000 Credit card balance250 ______ $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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 13 Savings and Wealth Change in Wealth Saving + Capital gains - Capital loss

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 14 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 the fall in stock prices was offset by rising home values

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 15 Why Do People Save? Life-Cycle Saving Saving to meet long-term objectives, such as retirement, college attendance, or the purchase of a home

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 16 Why Do People Save? Precautionary Saving Saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 17 Why Do People Save? Bequest Saving Saving done for the purpose of leaving an inheritance

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 18 Why Do People Save? Economic Naturalist Why do Japanese households save so much?  Life-cycle motive oLong life expectancy oRetire relatively early oHousing prices are very high and down payment requirements are also high

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 19 Why Do People Save? Economic Naturalist Why do Japanese households save so much?  Bequest motive oParents, who live with their children after retirement, leave a large inheritance

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 20 Why Do People Save? Economic Naturalist Why do Japanese households save so much?  Precautionary motive oVery high job security reduces the precautionary motive

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 21 Why Do People Save? Saving and the Real Interest Rate The higher the real rate the greater the reward from saving.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 22 Why Do People Save? Example By how much does a high savings rate enhance a family’s future living standard?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 23 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 24 Why Do People Save? Observation If people are target savers, a high real interest rate may reduce saving.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 25 Why Do People Save? Saving, Self-Control, and Demonstration Effects Self-Control Hypothesis  People lack the self-control to save

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 26 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 27 Why Do People Save? Saving, Self-Control, and Demonstration Effects Factors that may reduce self-control and savings  Home equity loans  Credit cards with high borrowing limits

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 28 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 29 Why Do People Save? Economic Naturalist Why do U.S. households save so little?  Life-cycle motive oSocial security and Medicare oLow down payment requirements for home mortgages

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 30 Why Do People Save? Economic Naturalist Why do U.S. households save so little?  Precautionary motive oStable economic performance oStrong capital gains

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 31 Why Do People Save? Economic Naturalist Why do U.S. households save so little?  Self-control effect oU.S. financial markets may have made it “too” easy to borrow

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 32 Why Do People Save? Economic Naturalist Why do U.S. households save so little?  Demonstration effect oIncreased real wage inequality

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 33 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 34 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 35 National Saving and Its Components The Measurement of National Saving National Saving (S) = Y - C - G

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 36 U.S. National Saving Rate,

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 37 Rich Countries Dis-saving Economist Magazine, Sep. 16, 2005: “Don’t Blame Savers”

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 38 National Saving and Its Components Private and Public Components of National Saving National Saving (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 = S private = Y - T - C Public saving = S public = T - G

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 39 National Saving and Its Components Private and Public Components of National Saving Two components of private saving (S private =Y - T - C)  Household (personal) saving  Business saving

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 40 National Saving and Its Components Private and Public Components of National Saving S public = T - G Includes  Federal  State  Local

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 41 National Saving and Its Components Private and Public Components of National Saving S = (Y - T - C) + (T - G) S = S private + S public National Saving (S) is composed of saving by households, businesses, and government (federal, state, and local) PrivatePublic

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 42 National Saving and Its Components Government Budget Deficit The excess of government spending over tax collections (G - T)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 43 National Saving and Its Components Government Budget Surplus The excess of government tax collections over government spending (T - G) The government budget surplus equals public saving

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 44 National Saving and Its Components Public Saving and the Government Budget 2000 S public = T - G  Federal: = 2, ,828.3  State & local: 32.8 = 1, ,189.8  S public = = 3, ,018.1

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 45 National Saving and Its Components Public Saving and the Government Budget 1995 S public = T - G  Federal: = 1, ,634.7  State & local: =  S public = = 2,

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 46 The Three Components of National Saving,

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 47 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 48 National Saving and Its Components Is Low Household Saving a Problem? Observations: Macroeconomic Perspective  National saving has been reasonably stable despite the decline in household saving.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 49 National Saving and Its Components Is Low Household Saving a Problem? Observations: Macroeconomic Perspective  National saving, while relatively low, has been sufficient to allow the U.S. to become one of the world’s most productive economies.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 50 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 51 Investment and Capital Formation Investment 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 52 Investment and Capital Formation 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)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 53 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 54 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 55 Investment and Capital Formation Factors that Determine the Investment Decision Measuring the costs  Real interest rate (opportunity cost)  Price of capital goods

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 56 Investment and Capital Formation Factors that Determine the Investment Decision Measuring the benefits  Value of marginal product oOperating expense oMaintenance expense oTax liability  Influenced by the relative price of the good or service produced by the capital

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 57 Investment and Capital Formation Economic Naturalist Why has investment in computers increased by so much in recent decades?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 58 Investment in Computers and Software,

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 59 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 Saving (I) The quantity demanded for saving is inversely related to r.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 60 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 61 The Supply and Demand For Savings Saving and investment Real interest rate (%) Investment I Saving S S, I r

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 62 The Effect of a New Technology on National Saving and Investment Saving and investment Real interest rate (%) I r E S I’ r’ F New Technology Raises the marginal productivity of capital This increases the demand for capital

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 63 The Effects of An Increase in the Government Budget Deficit On National Saving and Investment Saving and investment Real interest rate (%) S I r E r’ F S’ Increases in the government budget deficit: Reduces S public and national saving r will increase S & I will fall

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Saving and Capital Formation Slide 64 Saving, Investment, and Financial Markets Crowding Out The tendency of increased government deficits to reduce investment spending

MBMC End of Chapter End of Chapter