Savings, Capital Formation and Financial Markets

Savings and Wealth

• Saving is current income minus spending on current needs

  • The saving rate is saving divided by income

  • Examples: personal savings, money held in bank accounts, investment accounts, retirement accounts, and other financial assets

• Wealth is the value of assets minus liabilities

  • Assets are anything of value that one owns

  • Liabilities are the debts one owes

  • The balance sheet is a list of an economic unit’s assets and liabilities

    • Specific date

    • Economic unit (business, household, etc.)

Flow Values

• A flow value is defined per unit of time

• Dynamic movement of goods, services, or money over time and measured as a rate

  • Income 

  • Spending

  • Saving 

  • Wage

• A stock value is defined at a specific point in time and is static

  • Wealth

  • Debt

  • Investment / Saving flow

• The flow of savings causes the stock of wealth to change

  • Every dollar a person saves adds to his wealth

• A high rate of saving today leads to an improved standard of living in the future

• In general, flows and stocks are complementary concepts in economics. Flows help to explain changes in the economy over time, while stocks provide a snapshot of the current state of the economy

• Both concepts are important for understanding economic trends and making economic policy decisions

Capital Gains and Losses

Wealth changes when the value of your assets change

• Capital gains increase the value of existing assets

  • Higher value for stock

  • Higher housing values

  • Selling price higher than purchase price

  • Capital gains are taxed at a lower rate than ordinary income to incentivize investment and stimulate economic growth

• Capital losses decreases the value of existing assets

  • Car accident damages bumper and front headlight

  • Selling an asset at a price that is lower than its purchase price

    • Change in wealth = Saving + Capital gains – Capital losses

American Household Wealth in the 1990s and 2000s

• The dot-com boom and the housing market bubble contributed to rising household wealth, while increased access to credit led to higher levels of household debt

• Stock prices and house prices rose rapidly

  • Capital gains on stocks and housing increased household wealth

  • May have decreased household savings

  • Households were able to borrow against increasing capital gains

• Stock market declined, 2000 – 2002

  • Household savings remained low

  • Value of privately-owned homes increased rapidly

• Overall, the trends in household wealth and savings patterns during the 1990s and early 2000s were characterized by a significant increase in wealth, driven by the housing market and the stock market, but also a decline in savings rates and a significant increase in household debt

• These trends would eventually contribute to the financial crisis of 2008

Reasons for Household Saving

Life-Cycle Saving:

to meet long-term objectives - expenditures

• Retirement

• Home purchase

• Children's college attendance

• Healthcare costs

Precautionary Saving:

for protection against setbacks and income fluctuations

• Loss of job

• Medical emergency

Bequest Saving:

To leave an inheritance:

• Mainly higher income groups

Wealth Accumulation:

Wealth can be used to purchase assets, such as a home or a business, that generate income or appreciate in value over time

Consumption Smoothing:

People save to smooth out their consumption over their lifetime. By saving during periods of high income and consuming during periods of low income, individuals can maintain a relatively stable standard of living throughout their lifetime

Why do People Save

Life-Cycle Saving:

• Early Years

  • Borrowing: Consumption > Income

  • Substituting current for future consumption

• Middle Years

  • Saving: Consumption < Income

  • Substituting future for current consumption

• Retirement

  • Dis-Saving: Consumption > Income

  • Consuming wealth

• This theory suggests that individuals save when they are younger and have relatively low incomes and consume when they are older and have higher incomes

Savings and the Real Interest Rate

• Savings often take the form of financial assets that pay a return

• Interest-bearing checking

• Bonds

• Savings

• Mutual funds

• Stocks

• The real interest rate (r) is the nominal interest rate (i) minus the rate of inflation (π)

  • The increase in purchasing power from a financial asset

  • Marginal benefit of the extra saving

Thrifts and Spends

• Two otherwise identical families have different savings rates

  • Higher savings reduces current consumption

    • Thrifts consume $32,000 in 1995 and Spends consume $38,000

    • Thrifts get more unearned income

• Thrift's income grows faster

  • From 2000 on, Thrifts consume more than Spends

Explaining US Household Savings Rate

Savings rate may be depressed by

• Social Security, Medicare, and other government programs for the elderly

• Mortgages with small or no down payment

• Confidence in a prosperous future

• Increasing value of stocks and growing home values

• Readily available home equity loans

• Demonstration effects and status goods

• Low interest rates

National Savings

• Macroeconomics studies total savings in the economy

  • Household savings is one component

  • Business and government savings are other parts

• Start with the definition of production and income for the economy

  • Y = C + I + G + NX

    • Y = aggregate income or expenditures

    • C = consumption expenditure

    • G = government purchases of goods and services

    • I = investment spending

    • NX = net exports

Calculating National Savings

• Assume NX = 0 for simplicity

• National savings (S) is current income less spending on current needs

  • Current income is GDP or Y

• Spending on current needs

  • Exclude all investment spending (I)

  • Most consumption and government spending is for current needs

    • For simplicity, we assume all of C and all of G are for current needs

      • S = Y - C - G

Private Saving

• Private saving is household plus business saving

• Household's total income is Y

• Households pay taxes (T) from this income

  • Government transfer payments increase household income

    • Transfer payments are made by the government to households without receiving any goods in return

  • Interest is paid to government bond holders

• T = Taxes – Transfers – Government interest payments

• Private saving is after-tax income less consumption

  • SPRIVATE = Y – T – C

• Private saving is done by households and businesses

  • Household saving or personal saving is done by families and individuals

  • Business savings makes up the majority of private saving in the U.S.

    • Business savings is:

      • Revenues – Operating costs – Dividends to shareholders

    • Business savings can purchase new capital equipment

Public Saving and National Saving

• Public saving is the amount of the public sector's income that is not spend on current needs 

  • Public sector income is net taxes 

  • Public sector spending on current needs is G

    • SPUBLIC = T – G

• National saving (S) is private savings plus public savings

  • SPRIVATE + SPUBLIC = (Y – T – C) + (T – G)

    • S = Y – C – G

The Government Budget

Balanced budget occurs when government spending equals net tax receipts

• Government budget surplus is the excess of government net tax collections over spending (T – G)

  • Budget surplus is public savings

• Government budget deficit is the excess of government spending over net tax collections (G – T)

  • Budget deficit is public dissavings

Government Saving

Low Household and Government Savings

• National savings determines a country's ability to invest in new capital goods

  • Household savings has been low

  • Business saving has been significant

  • In the 1990s, government saving increased

• From 1960 to 2002, national saving rate was fairly stable

• 2002-2007 was characterized by a period of economic growth, low unemployment, housing and stock market boom and low interest rates, all of which encouraged more spending (less savings)

• From 2002 to 2007, government dissaving (rising deficits) contributed to a decline in the U.S. national saving rate

  • Tax cuts for high-income earners

  • Increased defence spending following 9/11

• Much larger government dissaving during 2007-2009 recession

  • Decrease in tax revenue and an increase in government spending on social welfare programs

Investment and Capital Formation

• Investment – the creation of new capital goods and housing – is necessary to increase average labour productivity

• National saving is the source of funding for 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)

• Firms buy new capital to increase profits

  • Cost-Benefit Principle

  • Cost is the cost of using the machine or other capital

  • Benefit is the value of the marginal product of the capital

The Investment Decision

• Two important costs

  • Price of the capital goods

  • Real interest rates

    • Opportunity cost of the investment

• Rate of return on an investment equals the value of marginal product expressed as a percentage of the purchase price

  • Value of Marginal Product = VMP

  • Price of Investment = PK

• Rate of return = VMP/PK

  • Real interest rate = r

  • If VMP/PK > r the investment is profitable

• Value of the marginal product (VMP) of the capital is its benefit

  • Net of operating and maintenance expenses and of taxes on revenues generated

  • Technical innovation increases benefits

  • Lower taxes increase benefits

  • Higher price of the output increases benefits

  • Influenced by the relative price of the good or service produced by the capital

Banking System

• Banks are the most important example of a class of institutions called financial intermediaries

• Financial intermediaries

  • Firms that extend credit to borrowers using funds raised from savers

• Banks help savers by evaluating the quality of potential borrowers for them, directing their savings towards higher-return, more productive investments

  • Provides information to savers about the possible uses of their funds

  • Help savers share the risks of individual investment projects

    • Risk sharing makes funding possible for projects that are risky but potentially very productive

• Banks and other intermediaries specialize in evaluating the quality of borrowers – Principle of Comparative Advantage

  • Banks have a lower cost of evaluating opportunities than an individual would

  • Banks pool the saving of many individuals to make large loans, spreading out risk

• Banks gather information about potential investments

  • Evaluate the options

  • Direct saving

  • Service provided to depositors

• Banks provide access to credit for small businesses and homeowners

  • May be the only source of credit for some investments

• These loans earn interest

Bonds and Stakes

• Bond: A legal promise to pay someone a debt, usually including both the principal amount and regular interest payments

• Principal amount: The amount originally lent

• Coupon rate: The interest rate promised when the bond is issued

• Coupon payments: Regular interest payments made to the bondholder

• A share of stock is a claim to partial ownership of a firm

  • Receive dividends, a periodic payment determined by management

  • Receive capital gains if the price of the stock increases

• Prices are determined in the stock market: Reflect supply and demand

Bond Markets, Stock Markets and the Allocation of Saving

• How do share and bond markets help ensure that available savings are devoted to the most productive uses?

• Two important functions served by these markets are:

  • gathering information about prospective borrowers

  • helping savers to share the risks of lending

• Companies considering a new issue of shares of bonds know that their recent performance and plans for the future will be carefully studied by financial investors

• Channel funds from savers to borrowers with productive investment opportunities

  • Sale of new bonds or new stock can finance capital investment

• Like banks, bond and stock markets allocate saving

  • Provision of information on investment projects and their risks

  • Provide risk sharing and diversification across projects

    • Diversification is spreading one's wealth over a variety of investments to reduce risk

Benefits of Diversification

• Vikram has $1,000 to invest in stocks

• Put all in one stock

  • 50% chance of 10% gain and 50% chance of zero

• Diversify and put half in each

  • One stock will gain 0% and the other gain 10% • Return is 5% with no risk

Saving, Investment and Financial Markets

• Supply of savings (S) is the amount of savings that would occur at each possible real interest rate (r)

  • The quantity supplied increases as r increases

• Demand for investment (I) is the amount of savings borrowed at each possible real interest rate

  • The quantity demanded is inversely related to r

Financial Market

• Equilibrium interest rate equates the amount of saving with the investment funds demanded

  • If r is above equilibrium, there is a surplus of savings

  • If r is below equilibrium, there is a shortage of savings

Financial Markets are Markets

• Financial markets adjust to surpluses and shortages as any other market does

  • Equilibrium Principle holds

• Changes in factors other than real interest rates will shift the savings or investment curves

  • New equilibrium

Technological Improvement

New technology raises marginal productivity of capital:

• Increases the demand for investment funds

•  Movement up the savings supply curve

• Higher marginal product of capital makes firms more eager to invest

• Investors race for new technologies

• Higher interest rate (as in the U.S. during the 90s)

• Higher level of savings and investment

• High rate of investment reflecting opportunities created by new technologies

Government Budget Deficit Increases

• Reduces national saving

• Government has dipped further into the pool of private savings to borrow funds to finance deficit

• Investors compete for a smaller quantity of available saving

• Movement up the investment curve

• Higher interest rate

• Investments less attractive

• Lower level of savings and investment

• Private investment is crowded out

Increase National Saving

• Policymakers know the benefits of increased national saving rates

  • Reducing government budget deficit would increase national saving

    • Political problems

  • Increase incentives for households

    • Federal consumption tax

    • Reduce taxes on dividends and investment income

• Higher national saving rate leads to greater investment in new capital goods and a higher standard of living

  

Austerity vs Stimulus

• What is the best fiscal policy, Austerity or Stimulus?

• Keynes favoured countercyclical policy: fiscal stimulus when under conditions like the 1930s - depressed income, high unemployment, low inflation, low interest rates. Aim to moderate the downturn

• But fiscal discipline during boom periods required to prevent over-heating, and to maintain debt sustainability

• Keynesian policy (“fine tuning”) fell into disfavour in part because it was hard to get the timing right: by the time fiscal stimulus became law, the recession would be over

• Pro-cyclical fiscal policy: Governments raise spending (or cut taxes) in booms; and are then forced to retrench in downturns, thereby exacerbating upswings & downswings

• The problem with Keynesian countercyclical fiscal policy: countries running big deficits even when the economy is strong, will be in trouble when the next downturn comes. No fiscal space

• When the Euro Debt Crisis hit in 2009, the bigger recessions went with the bigger fiscal contractions

Eurozone Debt Crisis

With austerity, debt/GDP ratios continued to rise sharply: Declining GDP outweighed progress on reduction of budget deficits

Government Borrowing and Bond Interest Rates

When a government borrows it issues debt in the form of bonds

The yield on a bond is the interest rate paid on state borrowing

• Purchasers of government bonds include pension funds, insurance companies and overseas investors

• The % yield in debt has been very low in recent years for countries such as the UK

UK Government Fiscal Austerity Policies

• Up until the Covid-19 Crisis, the UK had a fiscal deficit-reduction policy with the emphasis of cutting government spending

• These included deep cuts in real government spending (authorities, defence etc.), and welfare caps on annual welfare payments for each family

• In the July 2015 Budget, the chancellor George Osborne announced a new fiscal rule

• The government’s fiscal rules included a target for a budget surplus in “normal times” – when real annual GDP growth is above 1%

Arguments in Favour of Austerity

• Reducing debt in long-run interests of economy – helps to keep U.K. taxes lower

• Shrinking state encourages private sector growth

• High opportunity cost from billions on debt interest

• Cutting deficits increases investor confidence

• Upturn of cycle is time for government to borrow less – ahead of another downturn

• Some economists argued that the UK government austerity programme had resulted in growth that was higher than the European average and that the UK's economic performance had been much stronger than the International Monetary Fund had predicted

• Austerity can be expansionary in situations where government reduction in spending is offset by greater increases in aggregate demand

Arguments Against Austerity

• Austerity is self-defeating if it leads to deflation

• Government bond yields are low – a time to invest more

• Infrastructure investment will increase aggregate demand

• Wrong to cut spending when economy is in a zero interest rate environment – liquidity trap

• Economic growth is needed to pay back the debt and fiscal austerity makes this harder to achieve

• Keynesian macroeconomists argued that the austerity programme pursued by the Coalition Government in its first two years was both too severe and unnecessary and set back the economic recovery which was underway in the first half of 2010