Savings & Investment How investment raises full potential IdId Real Interest Rate $ Investment

Investment Investment (I) is a volatile & important component of GDP ( GDP = C + I + G + NX) –Changes with level of interest rates, investment outlook, etc… Investment has 3 subcomponents: –New capital expenditure by firms –New housing expenditure by households –Net inventories (unsold) Capital Goods: Most important component of I Firm builds new plants or order more machines etc… Raises long run full potential IdId Real Interest Rate $ Investment GDP counts goods when built----- not when sold!

Should a firm Invest? The real return on investment = ror –Return adjusted for inflation The price of the loan in real terms = r –Real interest rate = r If ror > r => then make investment MAKE THAT INVESTMENT! ROR > R $1,800 > $1,000 IdId Real Interest Rate $ Investment Example: Borrow $10,000 at 10% interest per year for capital investment Investment will raise profits by $1,800 per year Interest costs per year = $1,000

GDP Leakage GDP = C + I + G + (X – M) Leakage to GDP: S + T + M (S = Savings T= taxes M = Imports) Injections to GDP: I + G + X (Investment, Gov’t, Exports) Only in equilibrium do: Leakage = Injections S + T + M = I + G + X

Deriving Savings GDP is both total income and total expenditure: Y = C + I + G + NX Assume a closed economy – (one that does not engage in trade) Y = C + I + G Subtract C & G from both sides: Y – C – G = I

Derived Savings continued.. New Equation: Y – C – G = I This equals total income after paying for C & G Y – C – G is known as Savings (S) (what you don’t spend, you save) For the economy as a whole, savings must equal investment: { } Savings = Investment S = I

National, Private & Public National Saving –Income that remains after paying for C + G –Sum of public & private savings –Equals Y – C – G Private Saving –Income that households have left after taxes & consumption –Equals Y – T – C (T=Taxes) Public Saving –Amount of tax revenue government has left after spending –Equals T – G (T=Taxes) Y = C + I + G

Worksheet

Example: Investing Incentives A tax credit on capital investment Real Interest Rate Qty Loanable Funds D1D1 S1S r1r1 Q1Q1 E1E1 a) Demand Increases Due to Gov’t incentive b) AD ↑ because I ↑ c) More Investment today leads to ↑PPF & LRAS in long run Capital Goods D r2r2 Q2Q2 E2E2

Government Policies Gov’t Policies greatly affect Saving & Investment Gov’t Incentives: –Lower Taxes on Savings Interest on bonds, dividends on stocks ↑ supply of loanable funds which lowers the real interest rate –Tax credits on Investment Tax credits on purchase of capital goods

Changing Saving Incentives Loanable Funds (in billions of dollars) 0 Real Interest Rate Supply,S1S1 S2S which reduces the equilibrium interest rate and raises the equilibrium quantity of loanable funds. Demand Tax incentives for saving increase the supply of loanable funds... 5% $1,200 4% $1,600