Chapter 9: Saving and Capital Formation Notes

Chapter 9: Saving and Capital Formation

Learning Objectives

  • Explain the relationship between savings and wealth.
  • Discuss the reasons people save and how psychological factors influence saving.
  • Identify and apply the components of national saving.
  • Discuss the reasons firms choose to invest in capital.
  • Analyze financial markets using the tools of supply and demand.

Savings and Wealth

  • Definition of Saving:
    Saving is calculated as:
    Saving=Income−Spending\text{Saving} = \text{Income} - \text{Spending}
  • Definition of Wealth: Wealth is defined as: Wealth=Assets−Liabilities\text{Wealth} = \text{Assets} - \text{Liabilities}
    • Assets: Anything of value that one owns.
    • Liabilities: The debts one owes.
  • Balance Sheet:
    • A balance sheet lists an economic unit’s assets and liabilities.

Consuelo’s Balance Sheet Example

  • Assets:
    • Cash: $80
    • Checking account: $1,200
    • Shares of stock: $1,000
    • Car (market value): $3,500
    • Furniture (market value): $500
    • Total Assets:
      6,2806,280
  • Liabilities:
    • Student loan: $3,000
    • Credit card balance: $250
    • Total Liabilities:
      3,2503,250
  • Net Worth Calculation:
    Net Worth=Total Assets−Total Liabilities=6280−3250=3030\text{Net Worth} = \text{Total Assets} - \text{Total Liabilities} = 6280 - 3250 = 3030

Flow Values and Stock Values

  • Flow Values:
    • Defined per unit of time (e.g., income earned per year or monthly).
    • Examples include income, spending, saving, and wages.
  • Stock Values:
    • Defined at a specific point in time (a snapshot).
    • Examples include wealth and debt.
Example Calculation
  • You earn $30,000 and spend $25,000.
    • Saving = $30,000 - $25,000 = $5,000 (flow)
  • If you have:
    • $15,000 in the bank
    • $5,000 student loan
    • Wealth = $15,000 - $5,000 = $10,000 (stock)

Capital Gains and Losses

  • Capital Gains:
    • Increase the value of existing assets (e.g., stock value rising from $100 to $130).
    • Wealth increases by the amount of the capital gain.
  • Capital Losses:
    • Decrease the value of existing assets (e.g. due to a car accident).
  • Change in Wealth Calculation:
    Change in Wealth=Saving+Capital Gains−Capital Losses\text{Change in Wealth} = \text{Saving} + \text{Capital Gains} - \text{Capital Losses}

Three Reasons for Household Saving

  1. Life-Cycle Saving:
    • Saving aimed at long-term objectives such as retirement, buying a house, or funding children's education.
  2. Precautionary Saving:
    • Saving for unexpected setbacks like job loss or medical emergencies.
  3. Bequest Saving:
    • Saving intended to leave an inheritance for descendants.

Saving and the Real Interest Rate

  • How People Save:
    • Savings often consist of financial assets that generate returns, such as:
    • Bonds
    • Bank savings accounts
    • Mutual funds
    • Stocks
  • Real Interest Rate Definition: The real interest rate reflects how quickly purchasing power grows and is calculated as: r=i−πr = i - \pi Where:
    • $i$ = nominal interest rate
    • $\pi$ = inflation rate
  • Influence of the Real Interest Rate:
    • Affects the attractiveness of saving by indicating the return on savings adjusted for inflation.

Thrifty vs. Spendthrift Families

  • Spendthrift Family:
    • Saves only 5% of income, consumes more today.
  • Thrifty Family:
    • Saves 20% of income, consumes less today.
  • Implication:
    • Higher saving today leads to increased future consumption.
Financial Projection Example

Both families have a starting income of $40,000 and a real interest rate of 8%.

  • Spendthrift's Accumulation:
    • Savings Rate: 5%
    • Accumulated value over time will be less than the thrifty family's.
  • Thrifty's Accumulation:
    • Savings Rate: 20%
    • Their accumulated value will be higher over time.

Reasons for Low U.S. Household Savings

  • Factors Leading to Low Savings:
    • Easy borrowing contributes to increased spending.
    • Examples: Use of credit cards and consumer loans.
    • Social Security and Medicare reduces perceived need to save for retirement.
    • Mortgages with small down payments allow homeownership with less saving.
    • Optimism about future income diminishes perceived need to save.

Sources of National Saving

  • Macroeconomic Overview:
    • National saving is the aggregate total of all savings in the economy and comes from:
    • Households
    • Businesses
    • Government
  • National Income Identity:Y=C+I+G+NXY = C + I + G + NX Where:
    • $Y$ = aggregate income
    • $C$ = consumption expenditure
    • $I$ = investment spending
    • $G$ = government purchases
    • $NX$ = net exports

National Savings Calculation

  • For simplicity, assuming $NX = 0$:
    • National Saving (S):
    • S=Y−C−GS = Y - C - G
    • It represents the income left after consumption and government spending.

National Savings Trends (1960-2022)

  • Historically, the national savings rate has fluctuated, typically ranging between 12-14% in recent years.

Components of Private Saving

  • Private Saving Formula:
    • Private Saving=Household Saving+Business Saving\text{Private Saving} = \text{Household Saving} + \text{Business Saving}
    • Where:
    • Households Pay Taxes=T\text{Households Pay Taxes} = T
    • After-tax income is calculated as:
      After-tax income=Y−T\text{After-tax income} = Y - T
Private Saving Calculation
  • Private Saving Definition:
    • Remaining income after taxes and consumption.
    • Private Saving=Y−T−C\text{Private Saving} = Y - T - C

Business Saving in Private Savings

  • Business Saving Definition:
    Business Saving=Revenues−Operating Costs−Dividends to Shareholders\text{Business Saving} = \text{Revenues} - \text{Operating Costs} - \text{Dividends to Shareholders}
  • Example:
    • Apple retains part of its profit for reinvestment.

Public Saving and National Saving

  • Public Saving Formula:
    • Public Saving=Government Income NOT Spent\text{Public Saving} = \text{Government Income NOT Spent}
    • Measuring Government Income as net taxes ($T$)
    • Public saving calculation is crucial for determining:
    • S=S<em>PRIVATE+S</em>PUBLICS = S<em>{PRIVATE} + S</em>{PUBLIC}
    • Hence:
      S=Y−C−GS = Y - C - G

Government Budget Overview

  • Balanced Budget:
    • Occurs when government spending equals net taxes ($= 0$).
  • Implications of Deficit:
    • A deficit reduces public savings, subsequently lowering national saving and available funds for investment.
  • Implications of Surplus:
    • A budget surplus indicates positive public savings and healthy government finances.

Government Saving Figures

  • 2000 Federal Government Data:
    • Receipts: $2,067.8 billion
    • Expenditures: $1,908.1 billion
  • 2021 Federal Government Data:
    • Receipts: $4,319.0 billion
    • Expenditures: $7,154.4 billion
  • State and Local Governments Data:
    • Receipts and expenditures reflect varying levels of public saving across different governmental levels.

Investment and Capital Formation

  • Definition of Investment:
    • Investment represents the creation of new capital goods, including:
    • Machines
    • Factories
    • New housing
  • Cost-Benefit Principle:
    • Benefits must equal or exceed costs to justify investments.
    • Cost relates closely to the real interest rate.
    • Benefit is characterized by the value of the marginal product of capital (VMPK).
Case Study: Lauren and the Lawn Mower
  • Business Plan Analysis Steps:
    1. Net revenue:
    • Net revenue = $6,000, Taxes (20%) = $1,200, After-tax revenue = $4,800.
    1. Cost of Capital:
    • Interest cost: 0.06 × 4,000 = $240.
    1. Profit Calculation:
    • Profit from business = $4,800 - $240 = $4,560.
    1. Comparison with Outside Job:
    • Outside job (opportunity cost) = $4,400.
    1. Decision:
    • Choose to start the business:
      \text{Decision: } 4560 > 4400

The Investment Decision

  • Factors Leading to Firm Investments:
    • A firm decides to invest when the marginal product of capital exceeds cost.
    • Cost Components:
    • Price of capital goods
    • Real interest rate
  • Drivers of Increased Investment:
    • Technological innovations
    • Lower business taxes
    • Higher output prices
    • Lower real interest rates

Financial Market Dynamics

  • Equilibrium in Financial Markets:
    • The real interest rate adjusts to equalize saving and investment.
    • If the real interest rate is too high:
    • Saving > Investment → surplus → interest rate falls.
    • If too low:
    • Investment > Saving → shortage → interest rate rises.
Financial Markets as Mechanisms of Adjustment
  • Market forces shift saving and investment curves, leading to a new equilibrium when factors other than real interest rates change.

Technological Improvements Impacting Investment

  • New technology increases marginal productivity of capital:
    1. Raises demand for investment.
    2. Real interest rate rises due to competition for funds.
    3. Savings and investment increase, achieving a new equilibrium at a higher level.

Government Budget Deficit Effects

  • Impact of a Rising Government Budget Deficit:
    1. National saving decreases → Shifts saving curve left.
    2. Increase in real interest rates → Less available funds increases cost of borrowing.
    3. Resulting decrease in overall investment due to private investment being crowded out by government borrowing.

Summary Points

  • Distinction between saving and wealth.
  • Importance of flow vs. stock values in understanding economics.
  • Role of capital gains/losses in impacting wealth.
  • Reasons why households save and implications of interest rates.
  • Details on national savings components and calculations.
  • Overview of investment principles in macroeconomics, influenced by market conditions and government policies.