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

2. 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!

3. 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

4. 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

5. 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

6. 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

7. 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

8. Worksheet

9. Example: Investing Incentives A tax credit on capital investment Real Interest Rate Qty Loanable Funds D1D1 S1S1 -------------- ------------- 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 D2 ------------------- ------------------ r2r2 Q2Q2 E2E2

10. 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

11. Changing Saving Incentives Loanable Funds (in billions of dollars) 0 Real Interest Rate Supply,S1S1 S2S2 2.... which reduces the equilibrium interest rate... 3.... 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