Chapter 9: Savings and Capital Formation

Chapter 9: Savings 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

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

  • Saving is defined as current income minus spending on current needs.

  • Saving Rate:

    • Formula: Saving Rate = Saving / Income

  • Wealth is defined as the value of assets minus liabilities.

    • Assets: Anything of value that one owns.

    • Liabilities: Debts one owes.

    • The Balance Sheet is a list of an economic unit’s assets and liabilities.

Example of a Balance Sheet

  • Assets:

    • Cash: $80

    • Checking Account: $1,200

    • Shares of Stock: $1,000

    • Car (Market Value): $3,500

    • Furniture (Market Value): $500

    • Total Assets: $6,280

  • Liabilities:

    • Student Loan: $3,000

    • Credit Card Balance: $250

    • Total Liabilities: $3,250

  • Net Worth: Total Assets - Total Liabilities = $3,030

Flow Values and Stock Values

  • Flow Values: Defined per unit of time (e.g., income, spending, saving, wage).

  • Stock Values: Defined at a point in time (e.g., wealth, debt).

  • The flow of savings causes the stock of wealth to change; each dollar saved adds to overall wealth.

Capital Gains and Losses

  • Wealth changes when the value of your assets change.

  • Capital Gains: Increase the value of existing assets.

  • Capital Losses: Decrease the value of existing assets.

  • Change in Wealth formula:

    • Change in Wealth = Saving + Capital Gains - Capital Losses

Reasons for Households to Save

  1. Life-cycle Saving: To meet long-term objectives such as retirement, purchasing a home, and funding children's college tuition.

  2. Precautionary Saving: To protect against unforeseen setbacks such as job loss or medical emergencies.

  3. Bequest Saving: To leave an inheritance for offspring.

Savings and the Real Interest Rate

  • Savings often take the form of financial assets that pay returns, including:

    • Interest-bearing savings accounts

    • Bonds

    • Mutual funds

    • Stocks

  • Real Interest Rate (r) is calculated as:

    • Formula: r = i - p

    • Where i is the nominal interest rate and p is the rate of inflation.

  • Real interest rate reflects the increase in purchasing power from a financial asset.

  • Research indicates a high savings rate pays off in the long run, with higher real interest rates moderately increasing savings rates.

Maximizing Lifetime Well-Being

  • Barriers to Saving: Individuals may not save enough due to weak self-control leading to irrational spending habits (e.g., smoking, obesity, gambling).

  • Easy borrowing via credit cards and home equity loans supports high levels of current spending and lower savings.

  • Devices to Support Savings: Auto-enrollment in programs, such as the Mandatory Provident Fund (MPF) in Hong Kong, encourages savings by making withdrawals costly.

National Savings

  • Macroeconomics studies total savings within an economy, encompassing:

    • Household savings

    • Business and government savings

  • Definition of National Income:

    • Formula: Y = C + I + G + NX

    • Where Y = GDP or aggregate income, C = consumption expenditure, G = government purchases, I = investment spending, and NX = net exports. (Assume NX = 0 for simplicity)

  • National Savings (S): Current income less spending on current needs.

    • Investment spending is excluded from consumption and government spending categories.

    • Formula: S = Y - C - G

United States National Savings Data

  • National savings rates have fluctuated over years, showing trends indicative of broader economic conditions.

Private Savings

  • Definition: Private saving consists of both household and business saving.

  • Household's total income (Y) is subject to tax.

    • Government transfer payments (T) increase household income.

    • Private Saving Formula:

    • SPRIVATE = Y - T - C

Composition of Private Savings

  • Household saving involves families and individuals.

  • Business savings often make up the majority of private savings in the U.S.

    • Formula: Business Savings = Revenues - Operating Costs - Dividends.

  • Business savings facilitate the purchase of new capital equipment, essential for economic growth.

Public Savings

  • Definition: Public saving reflects the public sector's income not spent on current needs.

  • Public sector income is derived from net taxes (T).

  • Public Saving Formula: SPUBLIC = T - G

    • A balanced budget occurs when government spending (G) equals net tax receipts (T).

    • If T > G: Budget surplus occurs, indicating public savings.

    • If G > T: Budget deficit arises, resulting in public dissavings.

Components of National Savings

  • Total national saving (S) is composed of private savings (SPRIVATE) and public savings (SPUBLIC):

    • Formula: S = SPRIVATE + SPUBLIC = (Y - T - C) + (T - G) = Y - C - G

Investment and Capital Formation

  • Investment refers to the creation of new capital goods and housing, aimed at profit maximization.

  • The decision to invest is influenced by the Cost-Benefit Principle:

    • Costs include:

    • Purchase price of capital goods

    • Real interest rates

    • Benefits include:

    • Value of the marginal product of capital

    • Technical innovations

    • Tax reductions

    • Higher output prices

Saving, Investment, and Financial Markets

  • Supply of Savings (S): Refers to the amount of savings available at various real interest rates.

    • The quantity supplied of savings increases as real interest rates (r) increase.

  • Demand for Investment (I): Refers to the amount of borrowed savings at various real interest rates.

    • The quantity demanded of investment funds is inversely related to real interest rates.

  • The Equilibrium Interest Rate is where the quantity of savings equals the quantity of investment demanded.

Surplus and Shortage of Savings

  • If r is above equilibrium, there is a surplus of savings; if r is below equilibrium, there is a shortage.

    • Financial markets adjust to these conditions through changes in the price (r).

Technological Improvement

  • Advancements in technology raise the marginal productivity of capital, enhancing the demand for investment funds.

  • These improvements lead to a movement up the savings supply curve, resulting in higher interest rates and a higher level of savings and investment.

Government Budget Deficit

  • Increasing government budget deficits reduce national savings, causing:

    • Movement up the investment curve

    • Higher interest rates

    • Lower levels of savings and investment

    • Crowding out of private investment

Increasing National Saving

  • Policymakers recognize the benefits of raising national saving rates but face political issues.

    • Strategies include reducing government deficits to improve national savings.

    • Additional methods may involve incentivizing households via:

    • Implementing federal consumption tax

    • Reducing tax burdens on dividends and investment income

  • An increase in the national saving rate promotes greater investment in new capital goods and improves long-term standards of living.

Chapter 9 Highlights

  • Financial Markets

  • Investment and Capital

  • Low Household Saving

  • Private Saving

  • National Saving

  • Wealth

  • Public Saving

  • Interest Rate

  • Capital Gains and Losses

  • Government Budget