ECO2103

Macroeconomics

© 2022 Singapore Institute of Management Group Limited

 Lecture 4
Saving, Capital Formation and Financial
Markets

Ref:
Tan Khay Boon, Macroeconomics,
SIM Global Education, 2016
Session 4
2
Learning Outcomes
1. Define savings, wealth and distinguish
between savings and wealth
2. Analyse the reasons for saving
3. Define and calculate national savings
4. Analyse interest rate and investment in
the financial market
5. Analyse the value of stock and bonds
Savings and Wealth

• Key macroeconomic objective of

economic growth requires investment

• Investment is financed by savings

• Higher savings lead to more investment

that raises future standard of living

4
Savings and Wealth
• Savings is current income minus spending on current
needs
– The savings rate is savings divided by income
– National savings rate = S ÷ GDP
• 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.)
8-5
Individual Balance Sheet

Assets Liabilities
Cash $100 Student loans $2,000
Savings Deposit $500 Credit card debts $600
Shares of stock $1,200
Car (market value) $5,000

Total $6,800 $2,600

Net worth $4,200

8-6
 Capital Gains and Losses

• Wealth changes when the value of your assets

change
– Capital gains increase the value of existing assets
• Higher value for stocks and shares
– Capital losses decreases the value of existing
assets
• Depreciation of car

Change in wealth = Savings + Capital gain – Capital loss

8-7
Flow Values and Stock Values
• A flow value is measured over a period of time
– Income ─ Spending
– Savings ─ Wages
• A stock value is defined at a point in time
– Wealth ─ Debt
• 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
8-8
National Savings
• Macroeconomics studies total savings in the economy
– Household savings and business savings is one component
– Government savings is other part
• Start with the definition of production and income for the
economy
Y = C + I + G + NX
Y = aggregate income
C = consumption expenditure G = government purchases of
goods and services
I = investment spending NX = net exports

8-9
Calculate 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
8-10
Private Savings
• Private savings is household plus business savings
• Household's total income is Y
• Households pay net 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

8-11
Private Savings
• Private savings is after-tax income less consumption
SPRIVATE = Y – T – C
• Private savings is done by households and businesses
– Household savings or personal savings is by families and
individuals

– Business savings is

• revenues less operating costs less dividends to

shareholders
• used to purchase new capital equipment

8-12
Public Savings and National Savings

• Public savings 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 savings (S) is private savings plus public
savings
S = SPRIVATE + SPUBLIC = (Y – T – C) + (T – G)

S=Y–C–G

8-13
Public Savings and 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) > 0
• Budget surplus is public savings

– Government budget deficit is the excess of

government spending over net tax collections
(T - G) < 0
• Budget deficit is public dissavings

8-14
Three Reasons for Household Savings
• Life-cycle savings is to meet long-term
objectives
– Retirement
– Purchase a home
– Children's college attendance
• Life-cycle savings dependent on
– Life expectancy
– Retirement age: long retirement period
– Age structure of the population
– Attitude towards consumption (demonstration effect)
– Housing prices and down payment requirements
8-15
Three Reasons for Household Savings

• Precautionary savings is for protection

against setbacks
– Loss of job
– Medical emergency
• Precautionary savings affected 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
8-16
Three Reasons for Household Saving

• Bequest savings is to leave an

inheritance
– Mainly higher income groups
– Lack of welfare system in Asian countries
lead to need for higher savings rate

8-17
Investment and Capital Formation
• Investment is the creation of new capital
goods and housing
• 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
– Invest only when benefits exceeds cost
8-18
Online bakery
• Bakery business plan
– Advanced oven system = $2,000
• Interest on loan = 8%
• Assume the oven can be resold for $2,000
– Net revenue = $4,000
• Taxes = 16%
• Alternative work as tuition teacher can earn $2,500
after tax
– Cost – Benefit Principle indicates whether to
start online bakery

8-19
Online bakery

• Business plan analysis

Total revenue $4,000

Less taxes (16%) $640
Less opportunity cost $2,500
Equals VMP of bakery $860
Less interest (8%) $160
Equals net benefit $700

• Start online bakery

8-20
The Investment Decision
• Two important costs
– Price of the capital goods
– Real interest rates
• Opportunity cost of the investment (interest forgone)
• Benefit of investment is the additional revenue
generated from capital. Revenue must be net of
– operating and maintenance expenses
– taxes on revenues generated
• Additional revenue generated is also the value of
the marginal product of the capital
(VMP = P x MP capital)
– Technical innovation increases benefits (MPcapital)
– Higher price of the output increases benefits (P)
8-21
Saving - Investment Market
• 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
– Savings are channeled to investments
• Demand for investment (I) is the amount of
savings borrowed at each possible real
interest rate
– The quantity demanded is inversely related to
r
– Investments are financed from savings
8-22
Financial Market
• Equilibrium interest
rate equates the Saving S
amount of savings
with the investment

Real interest rate (%)

Surplus
r2
funds demanded
─ If r2 is above equilibrium, r
there is a surplus of r1
savings Investment I
Shortage

─ If r1 is below equilibrium,
there is a shortage of
savings S, I
Saving and investment
8-23
Financial 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

8-24
Technological Improvement

• New technology raises

S
marginal productivity
of capital
Real interest rate (%)

F
– Increases the demand
r' E for investment funds
r
I' – Movement up the
I savings supply curve
– Higher interest rate

Saving and Investment – Higher level of savings

and investment
8-25
Government Budget Deficit Increases

• Government budget
S'
S deficit increases
Real interest rate (%)

─ Reduces national savings

F ─ Movement up the
r' E investment curve
r ─ Higher interest rate
I ─ Lower level of savings and
investment
• Private investment is
crowded out
Saving and investment ─ Reduces potential growth

8-26
Increase National Savings
• Policymakers know the benefits of increased
national savings rate
– Reducing government budget deficit would increase
national savings
• Can be achieved through rise in taxes but unpopular
– Increase incentives for households to save
• Consumption tax (GST)
• Reduce taxes on dividends and investment income

• Higher national savings rate leads to greater

investment in new capital goods and a higher
standard of living
8-27
Financial System
• A successful economy allocates its savings to the most
productive investments
• The financial system improves the allocation of savings
– Provides information to savers about the possible uses of
their funds
– Help savers share the risks of individual investment
projects
• Savings often take the form of financial assets that pay a
return
– Interest-bearing checking ─ Bonds
– Savings ─ CDs
– Mutual funds ─ Stocks
Financial System

• 3 key components of financial system:

– Banking system
– Bond market
– Stock market
Banking System
• Financial intermediaries are firms that extend
credit to borrowers using funds raised from savers
– Thousands of commercial banks accept deposits from
individuals and businesses and make loans
• Attract savers by offering deposit interest rate
• Banks pool the savings of many individuals to make large loans
– 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
• Spread risk of investment across many savers
Banking System
• Banks gather information about potential
investments
– Evaluate the options
– Direct savings
– Service provided to depositors
• Banks provide access to credit for small
businesses and homeowners
– May be the only source of credit for some investments
• When banks make loans, they earn interest which,
in turn, is paid to the bank's depositors
The Banking System

• Having bank deposits makes payments

easier
– Checks
– ATMs
– Debit card
• Checks and debit cards are safer than cash
• Banks provide a record of your transactions
Bonds
• A bond is a legal promise to repay a debt
• Each bond (a paper certificate) specifies
– Principal amount, the amount originally lent
• Firm wishes to raise $10,000 to buy machines
• Issue 10 bonds of principal amount $1,000

– Maturity date, the date when the principal amount

will be repaid
• The term of a bond is the length of time from issue to
maturity

– Coupon rate & Coupon payments, the periodic

interest payments to the bondholder
• If the coupon rate is 5% and principal amount is $1000, then
the coupon payment a year is $50 until maturity
8-33
Bonds
• Corporations and governments issue bonds
• The coupon rate depends on
– Bond term
• 30 days to 30 years; longer term, higher coupon rate
– Credit worthiness of Bond Issuer
• Probability the issuer will default on repayment
• Higher risk, higher coupon rate

– Tax treatment for the coupon payments

• Government bonds are free from taxes
• Lower taxes, lower coupon rates
8-34
Bond Market
• Bonds can be sold before their maturity date
– Market value at any time is the price of the bond

– Price depends on the relationship between the coupon rate

and the interest rate in financial markets

• A two-year government bond with principal $1,000 is

sold for $1,000, 1/1/16
– Coupon rate is 5%

– $50 will be paid 1/1/17

– $1,050 will be paid 1/1/18

• Bond's price when sold depends on the prevailing

interest rate
8-35
Selling a Bond
• Offer for sale: bond with payment of $1,050 due
in one year
• The competition: a new one-year bond with
principal of $1,000 and coupon rate of 6%
– Pays $1,060 in one year
• Year-old bond with 5% coupon rate is less
valuable than the new bond
– Price of the used bond will be less than $1,000
(Bond price) (1.06) = $1,050
Bond price = $990.57
• Bond prices and interest rates are inversely
related
8-36
Selling a Bond
• If market interest rate falls to 4%, new one-year
bond with principal of $1,000 and will have
coupon rate of 4%
– Pays $1,040 in one year
• Year-old bond with 5% coupon rate is more
attractive than the new bond
– Price of the used bond will be more than $1,000
(Bond price) (1.04) = $1,050
Bond price = $1009.62
• Bond prices and interest rates are inversely
related
8-37
Stocks

• 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

8-38
Stock Price
• New company with estimated dividend of $1 in 1
year
– Estimated selling price of stock will be $10 in 1 year
– Interest rate is 5%
• Value of the new stock is $11 in 1 year
(Stock price) (1.05) = $11
Stock price = $10.48
– Value would be higher if:
• Dividend were higher
• Price of stock in one year were higher
• Interest rate were lower

8-39
Risk Premium

• Shares are considered more risky than bonds

• Uncertain about when dividends are paid out
and if there will be capital gains
• To encourage investors to hold more risky
assets, a risk premium is required
• Risk premium is the rate of return investors
require to hold risky assets minus the rate of
return on safe assets

8-40
Risk Premium

• Suppose interest on a safe investment

(govt bond) is 6%
– Stocks are more risky, so 10% return is required
– Stock will sell for $10 in 1 year; dividend will be $1
(Stock price) (1.10) = $11
Stock price = $10
• Risk aversion increases the return required of a
risky stock and lowers the selling price

8-41
Bond Markets and Stock Markets

• 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

8-42
SUMMARY
• In general,
savings = current income – spending on current goods
• The savings rate is the percentage of
income that is saved
• Wealth, or net worth, is the market value of
assets – liabilities
• Savings is a flow, being measured in dollars
per unit of time; wealth is a stock, measured
in dollars at a point in time
SUMMARY

• The savings of an entire country is national

savings and is defined by S = Y – C – G,
where
Y = total output or income,
C = consumption spending
G = government purchases
SUMMARY
• National savings can be divided up into
– private savings (Y – T – C)
– and public savings (T – G),

• T = taxes paid to the government less

transfer payments and interest paid by
the government to the private sector
• Private savings can be further divided into
household savings and business savings
SUMMARY
• Public savings is equivalent to the
government budget surplus;
– a budget deficit means public savings is
negative
• Individuals and households save for a
variety of reasons:
– life-cycle objectives
– need to be prepared for an emergency
(precautionary savings)
– the desire to leave an inheritance (bequest
saving)
SUMMARY
• The amount people save is also affected by
the real interest rate, which is the reward for
saving
• Investment is the purchase or construction
of new capital goods, including housing.
• Firms will invest in new capital goods if the
benefits of doing so outweigh the costs
 SUMMARY
• In the absence of international borrowing and
lending, the supply of and demand for national
savings must be equal
• The supply of national savings depends on the
– saving decisions of households and businesses (which
determine private savings)
– fiscal policy of the government (which determines public
savings)
• The demand for savings is the amount business
firms want to invest in new capital
SUMMARY
• Financial markets improve the allocation
of savings in 2 ways
– provide information about which possible
uses of funds are likely to be most
productive and hence pay the highest
return
– help savers share the risks of lending by
permitting them to diversify their financial
investments
Question 1
If consumption spending decreases by $5
million with no changes in income and taxes,
then:

(A)public saving increases.

(B)private saving decreases.
(C)public saving decreases.
(D)private saving does not change.
(E)private saving increases.
50
Answer to Question 1

51
Question 2
You are given the following information about the economy:
Household saving 300
Business saving 700
Government purchases 1,000
Government transfers and interest payments 500
Government tax collections 1,500
GDP 5,000

Private saving is _____ and national saving is ______.

(A) 300; -200
(B) 700; 0
(C) 1,000; 1,000
(D) 1,000; 1,500
(E) 1,000; 2,000
52
Answer to Question 2

53
Question 3
Holding other factors constant, if growing
concerns about job security raise precautionary
saving, then the real interest rate will _____ and
the equilibrium quantity of national saving and
investment will ____.

(A) increase; increase

(B) decrease; increase
(C) increase; decrease
(D) decrease; decrease
(E) increase; not change
54
Answer to Question 3

55
Question 4
Holding other factors constant, if new technology
comes online that allows machines to produce
manufactured goods more quickly and with fewer
defects, then the real interest rate will _____ and the
equilibrium quantity of national saving and investment
will ____.

A) increase; increase
B) decrease; increase
C) increase; decrease
D) decrease; decrease
E) increase; not change
56
Answer to Question 4

57
Question 5
As the real interest rate decreases the quantity
of saving supplied _____ and the quantity of
saving demanded ____.

(A) increases; increases

(B) decreases; increases
(C) increases; decreases
(D) decreases; decreases
(E) does not change; does not change

58
Answer to Question 5

59
Question 6
When the market interest rate increases, the
bond prices ______ and the share prices
______.

A) increase, increase.
B) decrease, decrease
C) increase, decrease.
D) decrease, increase.
E) does not change, increase
60
Answer to Question 6

61
Question 7
Johnny wants to start a car polishing business.
To do so, he needs to buy equipment that
costs $5,000. However he does not have the
funds and needs to borrow the $5,000 at an
interest of 10%. Should he start the business if
– Expected net revenue is $2,000
– Taxes on revenue is 20%
– Alternative job pays after tax income of
$1,200
– Equipment can be resold for $5,000
62
Answer to Question 7

8-63
Thank you