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.
  • Savings rate = 80/600 = 13.3 percent.
  • Wealth (net worth) is equal to assets minus liabilities.
  • Assets: anything of value that someone owns, either financial or real.
  • Liabilities: debts that someone owes to other parties.
  • Balance sheet lists assets and liabilities to determine net worth (wealth).
  • Net worth = assets minus liabilities.
  • Savings contributes to wealth.
  • Flow: A measure defined per unit of time (e.g., saving 20 per week).
  • Stock: A measure defined at a point in time (e.g., wealth of 3030 on 30th March 2023).
  • Flows change stocks.
  • Wealth can change due to changes in asset values.
  • Capital gain: increase in asset value.
  • Capital loss: decrease in asset value.
  • Change in wealth = savings + capital gains - capital losses

Why People Save

  • Three reasons why people save:
    • Lifecycle savings: long-term objectives (retirement, school fees, home).
    • Precautionary savings: for unexpected setbacks (job loss, health).
    • Bequest savings: to leave money to heirs or charity.
  • Reasons for declining saving rates in Australia:
    • Aged pension and compulsory superannuation.
    • Home ownership with small deposits and increased availability of mortgages.
    • Falling unemployment and improved labor market prosperity.
    • Good stock and housing market performance (capital gains).
  • Higher household savings rates during Covid-19.
  • Household savings have fallen due to the rise in the cost of living.
  • People save by making financial investments (savings deposits, bonds, stocks).
  • They receive interest on their financial investment, which increases their wealth.
  • Relevant interest rate for savings decisions is the real interest rate (r).
  • r = i(nominalinterestrate)−(nominal interest rate) -\pi (inflation rate).
  • The real interest rate is the “reward” for saving.
  • A higher interest rate makes savings more attractive.

National Savings

  • Macroeconomics focuses on the savings and wealth of a country (national savings or aggregate savings).
  • Savings represents current income minus spending on current needs.
  • Applies to three sectors: firms, households, and the government.
    • Firms: Income from sales, expenditure on wages, materials, interest, rent, dividends, and tax, the rest is business savings.
    • Households: Income from wages, interest, rent, and dividends. Expenditure on consumption, depreciation of assets and tax payments. the rest is household savings.
    • Government: Income from taxes. Expenditure on transfer payments and government purchases. The rest is government savings.
  • Y equals total income.
  • I is not part of current needs because investment is for the future.
  • CandandG include current needs expenditure.
  • National savings (NS) = Y – C – G.
  • National Income Identity: Y = C + I + G + NX,where, whereY can refer to production (GDP) or income, or output.
  • Assume exports equals imports so NX = 0.
  • Then, Y = C + I + G.
  • National savings divided into private and public savings.
  • T = taxes from the private sector to the government, minus transfer payments and interest payments made by the government to the private sector (net taxes).
  • NS = Y – C – G + T – T
  • NS = (Y – T – C) + (T – G)
  • S_{private} = Y – T – C
  • S_{public} = T – G
  • National savings NS = S{private} + S{public}
  • Government Budget Deficit when T – G < 0, decrease in public savings.
  • Government Budget Surplus when T – G > 0, increase in public savings.

Investment and Capital Formation

  • National savings provides resources for investment.
  • Investment is the creation of new capital goods and housing.
  • Critical to increasing productivity and improving living standards.
  • Investment usually takes place via financial markets where people borrow funds for their investment.
  • Investment decision determined by cost-benefit principle.
  • 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).
  • Cost side: price of capital goods and the real interest rate.
  • Real interest rate: real cost of paying back debt to borrow funds to purchase capital goods and measures the opportunity cost of investment.
  • Benefit side: the value of the marginal product of new capital.

Savings, Investment, and Financial Markets

  • In a closed economy, national savings funds investment.
  • Financial markets: the supply of savings is attributed to the households, firms and the government.
  • The demand for savings is by firms that want to borrow money to buy new capital.
  • The supply of savings funds the demand for savings.
  • In equilibrium: National Savings = Investment.
  • Demand and supply model to analyze financial markets.
    • The equilibrium amount of savings and investment in the economy.
    • The prevailing real interest rate.
  • The savings-investment model has national savings and investment on the horizontal axis.
  • The vertical axis is the real interest rate.
  • The supply of national savings (NS) is an upward-sloping curve.
  • Increases in the real interest rate increases savings.
  • Savings are demanded by firms wishing to invest in new capital goods.
    • Borrowing money in the financial market or Using their own accumulated profits.
  • The demand for savings is the investment curve (I).
  • 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.
  • Downward sloping because a higher real interest rate raises the cost of borrowing and decreases a firm’s willingness to invest.
  • In equilibrium, the desired level of investment (demand for savings) and desired level of national savings (supply of savings) are equal.
  • 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*.
  • The real interest rate acts as the “price” for savings.
  • NS = I
  • If NS > I, excess supply of savings which would push down the real interest rate.
  • If NS < I, excess of demand for savings which would push up the real interest rate.
  • A change in the real interest rate causes movement along the curve.
  • A change in other factors causes the curves to shift.
  • Factors that will cause the demand for investment to change:
    • New technology.
    • Investment tax credit policy.
  • Anything that changes the marginal product of the investment (i.e. the returns to the investment) will shift the demand for investment funds
  • Anything that decreases the marginal product of the investment will reduce the demand for investment funds, at every interest rate level.
  • Anything that increases the marginal product of the investment will increase the demand for investment funds, at every interest rate level.
  • An increase in demand for investment will shift the curve to the right whereas a decrease shifts it to the left.
  • New technology creates profit opportunities and increases the marginal product of capital.
  • Increase in the marginal product of capital at any given level of the real interest rate, makes firms eager to invest.
  • 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
  • The real interest rate increase reflects an increase for the demand for funds by investors.
  • Quantity of savings increases because of the incentive of higher returns (hence NS* becomes NS1).
  • Factors that will cause the supply of savings to change:
    • Changes in the government’s level of spending (budget).
  • Any other factor that changes savings in the economy will shift the supply of savings.
  • Anything that makes households, businesses or governments choose to change their saving rate will shift the supply curve.
  • 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.
  • The Government increases its savings, and hence has a government budget surplus T – G > 0
  • Increases the supply of savings and will shift the savings curve to the right.
  • Real interest rate would fall from r* to r1.
  • 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.