ECON1102 Topic 2 Notes

Savings and Wealth

  • Savings is current income minus current spending on goods and services.
  • Savings rate is the amount of savings as a proportion of income.
  • Example: Earning 600perweek,spending600 per week, spending520, savings is 80.</li><li>Savingsrate=80.</li> <li>Savings rate =80/600 = 13.3percent.</li><li>Wealth(networth)isequaltoassetsminusliabilities.</li><li>Assets:anythingofvaluethatsomeoneowns,eitherfinancialorreal.</li><li>Liabilities:debtsthatsomeoneowestootherparties.</li><li>Balancesheetlistsassetsandliabilitiestodeterminenetworth(wealth).</li><li>Networth=assetsminusliabilities.</li><li>Savingscontributestowealth.</li><li>Flow:Ameasuredefinedperunitoftime(e.g.,savingpercent.</li> <li>Wealth (net worth) is equal to assets minus liabilities.</li> <li>Assets: anything of value that someone owns, either financial or real.</li> <li>Liabilities: debts that someone owes to other parties.</li> <li>Balance sheet lists assets and liabilities to determine net worth (wealth).</li> <li>Net worth = assets minus liabilities.</li> <li>Savings contributes to wealth.</li> <li>Flow: A measure defined per unit of time (e.g., saving20 per week).
  • Stock: A measure defined at a point in time (e.g., wealth of 3030on30thMarch2023).</li><li>Flowschangestocks.</li><li>Wealthcanchangeduetochangesinassetvalues.</li><li>Capitalgain:increaseinassetvalue.</li><li>Capitalloss:decreaseinassetvalue.</li><li>Changeinwealth=savings+capitalgains−capitallosses</li></ul><h3id="whypeoplesave">WhyPeopleSave</h3><ul><li>Threereasonswhypeoplesave:<ul><li>Lifecyclesavings:long−termobjectives(retirement,schoolfees,home).</li><li>Precautionarysavings:forunexpectedsetbacks(jobloss,health).</li><li>Bequestsavings:toleavemoneytoheirsorcharity.</li></ul></li><li>ReasonsfordecliningsavingratesinAustralia:<ul><li>Agedpensionandcompulsorysuperannuation.</li><li>Homeownershipwithsmalldepositsandincreasedavailabilityofmortgages.</li><li>Fallingunemploymentandimprovedlabormarketprosperity.</li><li>Goodstockandhousingmarketperformance(capitalgains).</li></ul></li><li>HigherhouseholdsavingsratesduringCovid−19.</li><li>Householdsavingshavefallenduetotheriseinthecostofliving.</li><li>Peoplesavebymakingfinancialinvestments(savingsdeposits,bonds,stocks).</li><li>Theyreceiveinterestontheirfinancialinvestment,whichincreasestheirwealth.</li><li>Relevantinterestrateforsavingsdecisionsistherealinterestrate(r).</li><li>3030 on 30th March 2023).</li> <li>Flows change stocks.</li> <li>Wealth can change due to changes in asset values.</li> <li>Capital gain: increase in asset value.</li> <li>Capital loss: decrease in asset value.</li> <li>Change in wealth = savings + capital gains - capital losses</li> </ul> <h3 id="whypeoplesave">Why People Save</h3> <ul> <li>Three reasons why people save:<ul> <li>Lifecycle savings: long-term objectives (retirement, school fees, home).</li> <li>Precautionary savings: for unexpected setbacks (job loss, health).</li> <li>Bequest savings: to leave money to heirs or charity.</li></ul></li> <li>Reasons for declining saving rates in Australia:<ul> <li>Aged pension and compulsory superannuation.</li> <li>Home ownership with small deposits and increased availability of mortgages.</li> <li>Falling unemployment and improved labor market prosperity.</li> <li>Good stock and housing market performance (capital gains).</li></ul></li> <li>Higher household savings rates during Covid-19.</li> <li>Household savings have fallen due to the rise in the cost of living.</li> <li>People save by making financial investments (savings deposits, bonds, stocks).</li> <li>They receive interest on their financial investment, which increases their wealth.</li> <li>Relevant interest rate for savings decisions is the real interest rate (r).</li> <li>r = i(nominalinterestrate)−(nominal interest rate) -\pi(inflationrate).</li><li>Therealinterestrateisthe“reward”forsaving.</li><li>Ahigherinterestratemakessavingsmoreattractive.</li></ul><h3id="nationalsavings">NationalSavings</h3><ul><li>Macroeconomicsfocusesonthesavingsandwealthofacountry(nationalsavingsoraggregatesavings).</li><li>Savingsrepresentscurrentincomeminusspendingoncurrentneeds.</li><li>Appliestothreesectors:firms,households,andthegovernment.<ul><li>Firms:Incomefromsales,expenditureonwages,materials,interest,rent,dividends,andtax,therestisbusinesssavings.</li><li>Households:Incomefromwages,interest,rent,anddividends.Expenditureonconsumption,depreciationofassetsandtaxpayments.therestishouseholdsavings.</li><li>Government:Incomefromtaxes.Expenditureontransferpaymentsandgovernmentpurchases.Therestisgovernmentsavings.</li></ul></li><li>(inflation rate).</li> <li>The real interest rate is the “reward” for saving.</li> <li>A higher interest rate makes savings more attractive.</li> </ul> <h3 id="nationalsavings">National Savings</h3> <ul> <li>Macroeconomics focuses on the savings and wealth of a country (national savings or aggregate savings).</li> <li>Savings represents current income minus spending on current needs.</li> <li>Applies to three sectors: firms, households, and the government.<ul> <li>Firms: Income from sales, expenditure on wages, materials, interest, rent, dividends, and tax, the rest is business savings.</li> <li>Households: Income from wages, interest, rent, and dividends. Expenditure on consumption, depreciation of assets and tax payments. the rest is household savings.</li> <li>Government: Income from taxes. Expenditure on transfer payments and government purchases. The rest is government savings.</li></ul></li> <li>Yequalstotalincome.</li><li>equals total income.</li> <li>Iisnotpartofcurrentneedsbecauseinvestmentisforthefuture.</li><li>is not part of current needs because investment is for the future.</li> <li>CandandGincludecurrentneedsexpenditure.</li><li>Nationalsavings(NS)=include current needs expenditure.</li> <li>National savings (NS) =Y – C – G.</li><li>NationalIncomeIdentity:.</li> <li>National Income Identity:Y = C + I + G + NX,where, whereYcanrefertoproduction(GDP)orincome,oroutput.</li><li>Assumeexportsequalsimportssocan refer to production (GDP) or income, or output.</li> <li>Assume exports equals imports soNX = 0.</li><li>Then,.</li> <li>Then,Y = C + I + G.</li><li>Nationalsavingsdividedintoprivateandpublicsavings.</li><li>.</li> <li>National savings divided into private and public savings.</li> <li>T=taxesfromtheprivatesectortothegovernment,minustransferpaymentsandinterestpaymentsmadebythegovernmenttotheprivatesector(nettaxes).</li><li>= taxes from the private sector to the government, minus transfer payments and interest payments made by the government to the private sector (net taxes).</li> <li>NS = Y – C – G + T – T</li><li></li> <li>NS = (Y – T – C) + (T – G)</li><li></li> <li>S_{private} = Y – T – C</li><li></li> <li>S_{public} = T – G</li><li>Nationalsavings</li> <li>National savingsNS = S{private} + S{public}</li><li>GovernmentBudgetDeficitwhen</li> <li>Government Budget Deficit whenT – G < 0,decreaseinpublicsavings.</li><li>GovernmentBudgetSurpluswhen, decrease in public savings.</li> <li>Government Budget Surplus whenT – G > 0,increaseinpublicsavings.</li></ul><h3id="investmentandcapitalformation">InvestmentandCapitalFormation</h3><ul><li>Nationalsavingsprovidesresourcesforinvestment.</li><li>Investmentisthecreationofnewcapitalgoodsandhousing.</li><li>Criticaltoincreasingproductivityandimprovinglivingstandards.</li><li>Investmentusuallytakesplaceviafinancialmarketswherepeopleborrowfundsfortheirinvestment.</li><li>Investmentdecisiondeterminedbycost−benefitprinciple.</li><li>Istheexpectedcostoftheinvestmentlessthantheexpectedbenefitoftheinvestment(equaltothevalueofthemarginalproductitprovides).</li><li>Costside:priceofcapitalgoodsandtherealinterestrate.</li><li>Realinterestrate:realcostofpayingbackdebttoborrowfundstopurchasecapitalgoodsandmeasurestheopportunitycostofinvestment.</li><li>Benefitside:thevalueofthemarginalproductofnewcapital.</li></ul><h3id="savingsinvestmentandfinancialmarkets">Savings,Investment,andFinancialMarkets</h3><ul><li>Inaclosedeconomy,nationalsavingsfundsinvestment.</li><li>Financialmarkets:thesupplyofsavingsisattributedtothehouseholds,firmsandthegovernment.</li><li>Thedemandforsavingsisbyfirmsthatwanttoborrowmoneytobuynewcapital.</li><li>Thesupplyofsavingsfundsthedemandforsavings.</li><li>Inequilibrium:NationalSavings=Investment.</li><li>Demandandsupplymodeltoanalyzefinancialmarkets.<ul><li>Theequilibriumamountofsavingsandinvestmentintheeconomy.</li><li>Theprevailingrealinterestrate.</li></ul></li><li>Thesavings−investmentmodelhasnationalsavingsandinvestmentonthehorizontalaxis.</li><li>Theverticalaxisistherealinterestrate.</li><li>Thesupplyofnationalsavings(NS)isanupward−slopingcurve.</li><li>Increasesintherealinterestrateincreasessavings.</li><li>Savingsaredemandedbyfirmswishingtoinvestinnewcapitalgoods.<ul><li>BorrowingmoneyinthefinancialmarketorUsingtheirownaccumulatedprofits.</li></ul></li><li>Thedemandforsavingsistheinvestmentcurve(I).</li><li>Curveshowsthequantityofinvestmentinnewcapitalthatfirmswouldchooseiftheyborrowedinfinancialmarketsateachvalueoftherealinterestrate.</li><li>Downwardslopingbecauseahigherrealinterestrateraisesthecostofborrowinganddecreasesafirm’swillingnesstoinvest.</li><li>Inequilibrium,thedesiredlevelofinvestment(demandforsavings)anddesiredlevelofnationalsavings(supplyofsavings)areequal.</li><li>Wherethetwocurvesintersectgivesustheeconomy’slevelofsavingsandinvestmentandtherealinterestratethatwill‘clear’themarketforsavings,r∗.</li><li>Therealinterestrateactsasthe“price”forsavings.</li><li>, increase in public savings.</li> </ul> <h3 id="investmentandcapitalformation">Investment and Capital Formation</h3> <ul> <li>National savings provides resources for investment.</li> <li>Investment is the creation of new capital goods and housing.</li> <li>Critical to increasing productivity and improving living standards.</li> <li>Investment usually takes place via financial markets where people borrow funds for their investment.</li> <li>Investment decision determined by cost-benefit principle.</li> <li>Is the expected cost of the investment less than the expected benefit of the investment (equal to the value of the marginal product it provides).</li> <li>Cost side: price of capital goods and the real interest rate.</li> <li>Real interest rate: real cost of paying back debt to borrow funds to purchase capital goods and measures the opportunity cost of investment.</li> <li>Benefit side: the value of the marginal product of new capital.</li> </ul> <h3 id="savingsinvestmentandfinancialmarkets">Savings, Investment, and Financial Markets</h3> <ul> <li>In a closed economy, national savings funds investment.</li> <li>Financial markets: the supply of savings is attributed to the households, firms and the government.</li> <li>The demand for savings is by firms that want to borrow money to buy new capital.</li> <li>The supply of savings funds the demand for savings.</li> <li>In equilibrium: National Savings = Investment.</li> <li>Demand and supply model to analyze financial markets.<ul> <li>The equilibrium amount of savings and investment in the economy.</li> <li>The prevailing real interest rate.</li></ul></li> <li>The savings-investment model has national savings and investment on the horizontal axis.</li> <li>The vertical axis is the real interest rate.</li> <li>The supply of national savings (NS) is an upward-sloping curve.</li> <li>Increases in the real interest rate increases savings.</li> <li>Savings are demanded by firms wishing to invest in new capital goods.<ul> <li>Borrowing money in the financial market or Using their own accumulated profits.</li></ul></li> <li>The demand for savings is the investment curve (I).</li> <li>Curve shows the quantity of investment in new capital that firms would choose if they borrowed in financial markets at each value of the real interest rate.</li> <li>Downward sloping because a higher real interest rate raises the cost of borrowing and decreases a firm’s willingness to invest.</li> <li>In equilibrium, the desired level of investment (demand for savings) and desired level of national savings (supply of savings) are equal.</li> <li>Where the two curves intersect gives us the economy’s level of savings and investment and the real interest rate that will ‘clear’ the market for savings, r*.</li> <li>The real interest rate acts as the “price” for savings.</li> <li>NS = I</li><li>If</li> <li>IfNS > I,excesssupplyofsavingswhichwouldpushdowntherealinterestrate.</li><li>If, excess supply of savings which would push down the real interest rate.</li> <li>IfNS < I,excessofdemandforsavingswhichwouldpushuptherealinterestrate.</li><li>Achangeintherealinterestratecausesmovementalongthecurve.</li><li>Achangeinotherfactorscausesthecurvestoshift.</li><li>Factorsthatwillcausethedemandforinvestmenttochange:<ul><li>Newtechnology.</li><li>Investmenttaxcreditpolicy.</li></ul></li><li>Anythingthatchangesthemarginalproductoftheinvestment(i.e.thereturnstotheinvestment)willshiftthedemandforinvestmentfunds</li><li>Anythingthatdecreasesthemarginalproductoftheinvestmentwillreducethedemandforinvestmentfunds,ateveryinterestratelevel.</li><li>Anythingthatincreasesthemarginalproductoftheinvestmentwillincreasethedemandforinvestmentfunds,ateveryinterestratelevel.</li><li>Anincreaseindemandforinvestmentwillshiftthecurvetotherightwhereasadecreaseshiftsittotheleft.</li><li>Newtechnologycreatesprofitopportunitiesandincreasesthemarginalproductofcapital.</li><li>Increaseinthemarginalproductofcapitalatanygivenleveloftherealinterestrate,makesfirmseagertoinvest.</li><li>IncreaseindemandforsavingsandtheinvestmentcurvetoshifttoI1.Inturn,therealinterestincreasesfromr∗tor1sothatNS=I1</li><li>Therealinterestrateincreasereflectsanincreaseforthedemandforfundsbyinvestors.</li><li>Quantityofsavingsincreasesbecauseoftheincentiveofhigherreturns(henceNS∗becomesNS1).</li><li>Factorsthatwillcausethesupplyofsavingstochange:<ul><li>Changesinthegovernment’slevelofspending(budget).</li></ul></li><li>Anyotherfactorthatchangessavingsintheeconomywillshiftthesupplyofsavings.</li><li>Anythingthatmakeshouseholds,businessesorgovernmentschoosetochangetheirsavingratewillshiftthesupplycurve.</li><li>Anincreaseinthesupplyofsavingsshiftsthecurvetotherightwhereasadecreaseinthesupplyofsavingsshiftsittotheleft.</li><li>TheGovernmentincreasesitssavings,andhencehasagovernmentbudgetsurplus, excess of demand for savings which would push up the real interest rate.</li> <li>A change in the real interest rate causes movement along the curve.</li> <li>A change in other factors causes the curves to shift.</li> <li>Factors that will cause the demand for investment to change:<ul> <li>New technology.</li> <li>Investment tax credit policy.</li></ul></li> <li>Anything that changes the marginal product of the investment (i.e. the returns to the investment) will shift the demand for investment funds</li> <li>Anything that decreases the marginal product of the investment will reduce the demand for investment funds, at every interest rate level.</li> <li>Anything that increases the marginal product of the investment will increase the demand for investment funds, at every interest rate level.</li> <li>An increase in demand for investment will shift the curve to the right whereas a decrease shifts it to the left.</li> <li>New technology creates profit opportunities and increases the marginal product of capital.</li> <li>Increase in the marginal product of capital at any given level of the real interest rate, makes firms eager to invest.</li> <li>Increase in demand for savings and the investment curve to shift to I1. In turn, the real interest increases from r* to r1 so that NS = I1</li> <li>The real interest rate increase reflects an increase for the demand for funds by investors.</li> <li>Quantity of savings increases because of the incentive of higher returns (hence NS* becomes NS1).</li> <li>Factors that will cause the supply of savings to change:<ul> <li>Changes in the government’s level of spending (budget).</li></ul></li> <li>Any other factor that changes savings in the economy will shift the supply of savings.</li> <li>Anything that makes households, businesses or governments choose to change their saving rate will shift the supply curve.</li> <li>An increase in the supply of savings shifts the curve to the right whereas a decrease in the supply of savings shifts it to the left.</li> <li>The Government increases its savings, and hence has a government budget surplusT – G > 0</li><li>Increasesthesupplyofsavingsandwillshiftthesavingscurvetotheright.</li><li>Realinterestratewouldfallfromr∗tor1.</li><li>Agovernmentbudgetdeficitimplies</li> <li>Increases the supply of savings and will shift the savings curve to the right.</li> <li>Real interest rate would fall from r* to r1.</li> <li>A government budget deficit implies(T – G < 0)$$.
  • Would reduce the supply of savings and will shift the savings curve left, from NS to NS1.
  • Real interest rate would increase from r* to r1.
  • The higher interest rate makes investment less attractive so it decreases.
  • National savings also falls.
  • The Government’s borrowing crowds out private investment.
  • This is known as the crowding out effect.