Saving and Capital Formation Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University

Chapter 22: Saving and Capital Formation2Introduction  Why save? –To meet future expenditures. –To protect against an economic emergency. –To acquire income-producing assets. –For society as a whole, to produce capital goods, so to increase future income.

Chapter 22: Saving and Capital Formation3 Savings and Wealth  Saving –Current income minus spending on current needs. –Confusion Alert: Savings is accumulated saving_.  If all your wealth comes from saving_ (not spending), wealth = savings.  Saving Rate –Saving_ divided by income.

Chapter 22: Saving and Capital Formation4 Savings and Wealth  Example: –As a graduate student, I earned $10,000 a year, and spent about $9,700 a year. –My saving was $300 per year. –My saving rate was 300/10,000 = 3%.  Was my saving rate very low? –If I had saved $1,300 a year, my saving rate would have been 13%.

Chapter 22: Saving and Capital Formation5 Savings and Wealth  Example: –As a graduate student, I saved $300 per year. –Since I was in grad school for 6 years, I saved about $300 x 6 = $1800. –So my graduation-day savings were $1800.  Saving_ and Income are flows.  “Savings” is a stock.

Chapter 22: Saving and Capital Formation6 Household Saving Rate in the United States, Observations Household saving has fallen dramatically National saving has not declined in recent years Household Saving Household Income

Chapter 22: Saving and Capital Formation7 Gross Private Saving Rate in the United States, Observations Household saving has fallen dramatically National saving has not declined in recent years Household + Business Saving Household + Business Income

Chapter 22: Saving and Capital Formation8 Gross (National) Saving Rate in the United States, Observations Household saving has fallen dramatically National saving has not declined in recent years Household + Business + Government Saving Household + Business + Government Income

Chapter 22: Saving and Capital Formation9 Savings and Wealth  Wealth –The value of assets minus liabilities.  Assets –Anything of value that one owns.  Real Assets, like a car.  Financial Assets, like a savings account or a bond.  Liabilities –The debts one owes.

Chapter 22: Saving and Capital Formation10 Consuelo’s Balance Sheet Assets Cash$ 80 Checking account1,200 Shares of stock1,000 Car (market value)3,500 Furniture (market value) 500 Total Assets $6,280 Liabilities Student loan$3,000 Credit card balance250 ______ Total Liabilities 3,250 Net worth $3,030 Wealth ($3,030) = Assets ($6,280) - Liabilities ($3,250)

Chapter 22: Saving and Capital Formation11 Savings and Wealth  Flow –A measure that is defined per unit of time.  Saving is a flow and is defined per unit of time (saving/week).  Flow is the rate of change in the stock.  Stock –A measure that is defined at a point in time  Wealth is a stock and is defined at a point in time (wealth on a given date). Savings are a stock too.  Every dollar people save adds to their wealth.

Chapter 22: Saving and Capital Formation12 Savings and Wealth  Example SavingWealth

Chapter 22: Saving and Capital Formation13 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 Formation14 Assets Cash$ 80 Checking account1,200 Shares of stock (up by $500)1,500 Car (market value)3,500 Furniture (market value) 500 Total Assets $6,780 Liabilities Student loan$3,000 Credit card balance250 ______ Total Liabilities$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 Consuelo’s Balance Sheet After An Increase in the Value of Her Stocks

Chapter 22: Saving and Capital Formation15 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.

Why Do People Save?

Chapter 22: Saving and Capital Formation17 Why Do People Save?  Life-Cycle Saving –Saving to meet long-term objectives, such as retirement, college attendance, or the purchase of a home.  What is the effect of Social Security and Federal financial aid on this kind of saving?  Precautionary Saving –Saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency.  What is the effect of Medicare/aid on this kind of saving?  Bequest Saving –Saving done for the purpose of leaving an inheritance.  What is the effect of weak family ties on this kind of saving?

Chapter 22: Saving and Capital Formation18 Saving and Wealth  If people save for retirement or to diminish uncertainty, they save to accumulate wealth.  Suppose the value of my stock market (financial) investments, or that the value of my house goes up.  Then my wealth increases.  I will save less – consume more. –This is called the wealth effect. –The stock market boom of the 1990s and the housing boom of the 2000s have had this effect.

Chapter 22: Saving and Capital Formation19 Why Do People Save?  Saving and the Real Interest Rate –The higher the real rate the greater the reward from saving. –A greater reward may encourage a higher saving rate.  Financial Liberalization in developing countries was carried out with this rationale.

Chapter 22: Saving and Capital Formation20 Why Do People Save? Saving Real interest rate (%) Saving S S r r’ S’

Chapter 22: Saving and Capital Formation21 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’ wealth is $385,000 and Spends’ wealth is $77,000 Consumption Trajectories of the Thrifts and the Spends Example By how much does a high savings rate enhance a family’s future living standard?

Chapter 22: Saving and Capital Formation22 Why Do People Save? –If people are target savers, a high real interest rate may reduce saving. Saving Interest Income at 5%Wealth Saving Interest Income at 10%Wealth

Chapter 22: Saving and Capital Formation23 Why Do People Save?  Saving, Self-Control, and Demonstration Effects –Self-Control Hypothesis  People lack the self-control to save –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 Formation24 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.  Satisfaction depends on relative living standards.  An upward spiral of spending can occur, which reduces savings. –Increased real-wage inequality may contribute to this, as well as television and advertising, etc.

Components of National Saving

Chapter 22: Saving and Capital Formation26  The Measurement of National Saving –Real income or expenditures (Y) = Consumption (C) + Investment (I) + Government (G) + Net exports (NX)  Y = C + I + G + NX –Saving = Y - spending on current needs –If we were to assume NX = 0:  Y = C + I + G National Saving and Its Components

Chapter 22: Saving and Capital Formation27 Net Exports and Foreign Saving  NX = difference between foreign spending on our goods and our spending on foreign goods. –If NX < 0, it must be financed by borrowing from abroad. –In other words, foreigners must save. NX = foreign saving. –If NX < 0, foreign saving is positive. –See Chapter 24

Chapter 22: Saving and Capital Formation28  Saving = Y - spending on current needs  S = Y – C – G National Saving and Its Components

Chapter 22: Saving and Capital Formation29  The Measurement of National Saving –Determining spending on today’s 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. –National Saving (S) = Y – C – G National Saving and Its Components

Chapter 22: Saving and Capital Formation30 National Saving (S) = Y – C – G U.S. National Saving Rate,

Chapter 22: Saving and Capital Formation31  Private and Public Components of National Saving –National Saving (S) = Y - C - G S = Y - C - G + T - T S = Y - C - G + T - T S = (Y - T - C) + (T - G) S = (Y - T - C) + (T - G) –Private saving = S private = Y - T - C –Public saving = S public = T - G National Saving and Its Components

Chapter 22: Saving and Capital Formation32  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 –Private saving = S private = Y - T - C –Public saving = S public = T - G National Saving and Its Components

Chapter 22: Saving and Capital Formation33  Private and Public Components of National Saving –Two components of private saving (S private =Y - T - C) –Household (personal) saving –Business saving  Makes the majority of US private saving. National Saving and Its Components

Chapter 22: Saving and Capital Formation34  Private and Public Components of National Saving –S public = T - G –Includes  Federal  State  Local National Saving and Its Components

Chapter 22: Saving and Capital Formation35  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 PrivatePublic National Saving and Its Components

Chapter 22: Saving and Capital Formation36  Government Budget Deficit (S public < 0) –The excess of government spending over tax collections (G - T) > 0.  Government saving is negative: T < G.  Government Budget Surplus (S public > 0) –The excess of government tax collections over government spending (T - G) > 0.  Government saving is positive T > G –The government budget surplus equals public saving. National Saving and Its Components

Chapter 22: Saving and Capital Formation37  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 National Saving and Its Components

Chapter 22: Saving and Capital Formation38  Public Saving and the Government Budget –1995 S public = T - G  Federal: = 1, ,634.7  State & local: =  S public = = 2, National Saving and Its Components

Chapter 22: Saving and Capital Formation39 Public Saving,

Chapter 22: Saving and Capital Formation40 The Three Components of National Saving,

Chapter 22: Saving and Capital Formation41  Is Low Household Saving a Problem? –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. –The low household saving rate signals a problem of growing inequality in wealth among U.S. households. –It signals a consumerist attitude. National Saving and Its Components

Investment and Capital Formation

Chapter 22: Saving and Capital Formation43  Investment –Investment -- the purchase of new capital goods and housing -- is necessary to increase average labor productivity.  Capital goods will be accumulated only if firms want to purchase them. –National saving is the source of funding for investment. Investment and Capital Formation

Chapter 22: Saving and Capital Formation44  Investment –Investment spending is undertaken if it is expected to be profitable. Investment and Capital Formation Benefit from Investment Cost from Investment Profit Profit rate = VMP of capital Interest rate = r Profit

Chapter 22: Saving and Capital Formation45  Investment –The benefit must exceed the cost of the investment Investment and Capital Formation

Chapter 22: Saving and Capital Formation46  Investment –Suppose I want to buy a unit of capital. –While I have it, I receive the benefit of extra production, or rather, the benefit of the extra revenue that I get from selling that production. Marginal Product x Marginal Revenue = Value of the Marginal Product Investment and Capital Formation

Chapter 22: Saving and Capital Formation47  Investment –Suppose I want to buy a unit of capital. –I could borrow the money from the bank.  And pay the loan interest rate. –Alternatively, I could take out money from my bank account, and buy the machine with it.  And lose the saving interest rate. –Either way, the interest rate is a key determinant of the cost of buying the machine. Investment and Capital Formation

Chapter 22: Saving and Capital Formation48  Investment –The benefit must exceed the cost of the investment. In other words: –The value of marginal product of capital  After-tax net revenue per unit, minus the opportunity cost (the income from other activities that is foregone) –must exceed the real interest rate. Investment and Capital Formation

Chapter 22: Saving and Capital Formation49  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  value of liability (loan) = value of asset (mower) Investment and Capital Formation

Chapter 22: Saving and Capital Formation50  Example –Should Larry buy a riding lawn mower?  Net revenue $6,000  Less Taxes (20%) $1,200  Equal after-tax revenue$4,800  Less Opportunity Cost $4,400  Equals VMP of lawnmower $400 Investment and Capital Formation

Chapter 22: Saving and Capital Formation51  Example –Should Larry buy a riding lawn mower?  Net revenue $6,000  Less Taxes (20%) $1,200  Equal after-tax revenue$4,800  Less Opportunity Cost $4,400  Equals VMP of lawnmower $400  Less Interest (6%)$240  Equals Net Benefit$160 Investment and Capital Formation

Chapter 22: Saving and Capital Formation52  Factors that Determine the Investment Decision –Measuring the costs  Real interest rate  Price of capital goods –Suppose that VMP is constant at 400. –Then lower interest rates will raise the benefit of investment in capital goods. Investment and Capital Formation

Chapter 22: Saving and Capital Formation53 Investment and Capital Formation r = 12% r = 10% r = 8% r = 6% r = 4% Net Revenue Less Taxes After Tax Revenue Less Opp. Cost VMP Less Interest Net Benefit

Chapter 22: Saving and Capital Formation54  Factors that Determine the Investment Decision –Measuring the benefits  Value of marginal product –Productivity of Capital. –The relative price of the good or service produced by the capital. –Operating expense –Maintenance expense –Tax liability. Investment and Capital Formation

Chapter 22: Saving and Capital Formation55  Example –Suppose Larry owns a print shop. –He would like to buy more than one printer.  (it would allow him to run more than one print job at the same time). Each costs $5500. –Every extra printer brings extra production, but at a decreasing rate.  Larry has to run around from printer to printer.  There’s more of a chance for mistakes. –For simplicity, ignore taxes and opportunity costs. Investment and Capital Formation

Chapter 22: Saving and Capital Formation56 Investment and Capital Formation # Printers Total Product per year MP per year Price per print job = MR Value of the Marginal Product $ $ $ $ $ $ $0.500

Chapter 22: Saving and Capital Formation57 # printers r r =12% r =10% r = 8% r = 6% r = r = 4% Investment and Capital Formation Interest paid per printer = r * $5500 VMP: benefit of each additional printer

Chapter 22: Saving and Capital Formation58 12% 10% 8% 6% 4% Investment and Capital Formation Amount of Investment Interest Rate

Chapter 22: Saving and Capital Formation59 Investment and Capital Formation Investment Real interest rate (%) Investment I I r r’ I’

Chapter 22: Saving and Capital Formation60  Economic Naturalist –Why has investment in computers increased by so much in recent decades?  Because the marginal productivity of computers has increased tremendously.  Higher marginal productivity means higher value of the marginal product.  More computers become affordable, at the same level of interest rates, because they produce more.  The Investment Curve shifts to the right. Investment and Capital Formation

Chapter 22: Saving and Capital Formation61 # printers r r =12% r =10% r = 8% r = 6% r = r = 4% Investment and Capital Formation Interest paid per printer = r * $5500 VMP: benefit of each additional printer

Chapter 22: Saving and Capital Formation62 Investment and Capital Formation # printers r r =12% r =10% r = 8% r = 6% r = 4% Interest paid per printer = r * $5500 VMP: increased benefit of each additional printer

Chapter 22: Saving and Capital Formation63 Investment and Capital Formation Investment Real interest rate (%) I’ I r I

Chapter 22: Saving and Capital Formation64 Investment in Computers and Software,

Saving, Investment, and Financial Markets

Chapter 22: Saving and Capital Formation66  Savings (S) –Is the supply of saving –The quantity supplied of saving is directly related to the real interest rate (r)  Investment (I) –Is the demand for saving –The quantity demanded for saving is inversely related to r. Saving, Investment, and Financial Markets

Chapter 22: Saving and Capital Formation67  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. Saving, Investment, and Financial Markets

Chapter 22: Saving and Capital Formation68 Saving and investment Real interest rate (%) Investment I Saving S S, I r The Supply and Demand For Savings

Chapter 22: Saving and Capital Formation69 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 The Effect of a New Technology on National Saving and Investment

Chapter 22: Saving and Capital Formation70 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 The Effects of An Increase in the Government Budget Deficit On National Saving and Investment

Chapter 22: Saving and Capital Formation71  Crowding Out –The tendency of increased government deficits to reduce investment spending.  Higher public deficits reduce national saving.  Lower saving at any interest rate creates an excess demand for saving funds.  Interest rates rise, making investment more expensive.  Investment falls. Saving, Investment, and Financial Markets