1 Frank & Bernanke 3 rd edition, 2007 Ch. 9: Saving and Capital Formation

2 Introduction Motives for Saving Motives for Saving To meet future expenditures To meet future expenditures Protect against an economic emergency Protect against an economic emergency Produce capital goods Produce capital goods

3 What Is Saving? Saving at the household level is the amount of current income that is not currently consumed. Saving at the household level is the amount of current income that is not currently consumed. Joan has an income of $1000 this month. 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. 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 her saving?

4 What Is Saving? Saving at the household level is the amount of income that is added to wealth. 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. 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. 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? Why would Joan’s $150 in savings increase her wealth?

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

6 Savings and Wealth Capital Gains Capital Gains Increases in the value of existing assets Increases in the value of existing assets Capital Losses Capital Losses Decreases in the value of existing assets Decreases in the value of existing assets

7 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

8 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. 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 foreigners acquired assets here, then national savings will have to equal to capital formation. If no part of national saving is used to acquire wealth abroad and no foreigners acquired assets here, then national savings will have to equal to capital formation.

9 Household Saving Rate in the United States, Observations Household saving has fallen dramatically National saving has not declined in recent years &Update=Update&JavaBox=no#Mid

10 What Is Capital Formation? Net additions to the stock of capital 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 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. 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.

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

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

13 Home Example The Bank had no assets and 85 people deposited $1000 each - liabilities of $85K and cash (assets) of $85K. 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 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. 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. Its assets and liabilities are equal. The savings of the 85 people plus your $15K bought the new house. The savings of the 85 people plus your $15K bought the new house.

14 Home Example The financial savings of $100,000 is used to buy a new home. 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. 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%. You own 15% of the home and the savers own 85%. Without the existence of savings, the investments couldn’t have been financed. Without the existence of savings, the investments couldn’t have been financed.

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

16 Answers to Problem 1, p. 266

17 Answers to Problem 2, p. 267

18 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. 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. There are many reasons why people save and why people invest; but real interest rates appear as one of these reasons in both cases.

19 Why Do People Save? Life-Cycle Saving Life-Cycle Saving Saving to meet long-term objectives, such as retirement, college attendance, or the purchase of a home Saving to meet long-term objectives, such as retirement, college attendance, or the purchase of a home

20 Why Do People Save? Precautionary Saving Precautionary Saving Saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency Saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency

21 Why Do People Save? Bequest Saving Bequest Saving Saving done for the purpose of leaving an inheritance Saving done for the purpose of leaving an inheritance

22 Why Do People Save? Observation Observation If people are target savers, a high real interest rate may reduce saving. If people are target savers, a high real interest rate may reduce saving.

23 Why Do People Save? Payroll deductions for Christmas Clubs, retirement pension funds might increase savings by eliminating the temptation to spend the available income. 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. 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. Higher real interest rates might convince people to save more. Capital gains might reduce savings; capital losses might increase savings. Capital gains might reduce savings; capital losses might increase savings.

24 Self-Control Hypothesis George Lowenstein, Brian Knutson, Drazen Prelec (Neuron, 2007) George Lowenstein, Brian Knutson, Drazen Prelec (Neuron, 2007) People lack the self-control to save People lack the self-control to save Techniques to offset the lack of self-control and increase savings Techniques to offset the lack of self-control and increase savings Payroll savings Payroll savings Retirement accounts with limited withdrawals Retirement accounts with limited withdrawals Factors that may reduce self-control and savings Factors that may reduce self-control and savings Home equity loans Home equity loans Credit cards with high borrowing limits Credit cards with high borrowing limits

25 Why Do People Save? Demonstration effects Demonstration effects People use spending by others to measure the adequacy of their own spending. 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. When satisfaction depends on relative living standards, an upward spiral of spending can occur, which reduces savings.

26 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.

27 Why do Japanese households save so much? Life-cycle motive Life-cycle motive Long life expectancy Long life expectancy Retire relatively early Retire relatively early Housing prices are very high and down payment requirements are also high Housing prices are very high and down payment requirements are also high Bequest motive Bequest motive Parents, who live with their children after retirement, leave a large inheritance Parents, who live with their children after retirement, leave a large inheritance Precautionary motive Precautionary motive Very high job security reduces the precautionary motive Very high job security reduces the precautionary motive

28 Why do U.S. households save so little? Life-cycle motive Life-cycle motive Social security and Medicare Social security and Medicare Low down payment requirements for home mortgages Low down payment requirements for home mortgages Precautionary motive Precautionary motive Stable economic performance Stable economic performance Strong capital gains Strong capital gains Self-control effect Self-control effect U.S. financial markets may have made it “too” easy to borrow U.S. financial markets may have made it “too” easy to borrow Demonstration effect Demonstration effect Increased real wage inequality Increased real wage inequality

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

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

32 U.S. National Saving Rate,

33 Gross Saving &LastYear=2006&Freq=Qtr &LastYear=2006&Freq=Qtr

34 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%

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36 Low Household Savings By international standards, personal savings in the US are low and getting even lower. 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. 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. Increase in wealth might be the reason for decreasing household saving. Low savings and negative wealth for the poor households is a major concern. Low savings and negative wealth for the poor households is a major concern.

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

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

39 Investment in Computers and Software,

40 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.

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

42 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?

43 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

44 Increase in the Government Budget Deficit Saving and investment Real interest rate (%) S I r E r’r’ F S’ Increases in the government budget deficit: Reduces S public and national saving r will increase S & I will fall

45 Shifts What happens when stock market falls? What happens when stock market falls? What happens when war breaks out? What happens when war breaks out? What happens when a new child is born to the family? 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 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 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 working age? What happens when “baby boom” generation reaches retirement? What happens when “baby boom” generation reaches retirement?

46 Shifts What happens when price of computing power drops by 50%? What happens when price of computing power drops by 50%? What happens a new software increases the output of a computer? 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 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? What happens when the government puts an extra tax on mobile phones?

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