Chapter 18: Saving,

Capital Formation, and

Financial Markets

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Learning Objectives
1. Explain the relationship between
savings and wealth
2. Recognize and work with the
components of national saving
3. Understand the reasons people save
4. Discuss the reasons firms choose to
invest in capital rather than financial
assets
5. Analyze financial markets using the
tools of supply and demand
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Savings and Wealth

Recall the fable of the ant and the
grasshopper, which leads to the
moral: When times are good, the wise
put aside something for the future.
Saving is important both to
individuals and to nations.
People

save for retirement, kids

education, or a rainy day.
Nations save to produce new capital
goods
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Savings and Wealth

Saving is current income minus
spending on current needs
Saving

rate is saving divided by income

Wealth is the value of assets minus

liabilities
Assets

are the value that one owns

Liabilities are the debts one owes
Balance sheet is a list of assets and
liabilities

For a specific date

Economic unit (business, household, etc.)
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Marias Balance Sheet, 1/1/2011

Assets

Liabilities

Cash

$80

Checking account

1,200

Shares of stock

1,000

Car (market value)

3,500

Furniture (market
value)
Total

Student loan
Credit card
balance

$3,000
250

500
$6,280

$3,250
Net worth

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$3,030

Stocks and Flows

A stock variable is defined at a point in
time
Wealth

Debt

A flow variables is defined per unit of time

Income
Saving

Spending
Wage

The flow of saving 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
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Capital Gains and Losses

Wealth changes when the value of
your assets change
Capital

gains increase the value of

existing assets

Higher value for stock

Capital

losses decreases the value of

existing assets

Car accident damages bumper and front

headlight
Change in wealth =
Saving + Capital gains Capital losses
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Marias Balance Sheet, 2/1/2011

Assets

Liabilities

Cash

$80

Checking account

1,200

Shares of stock

1,500

Car (market value)

3,500

Furniture (market
value)
Total

Student loan
Credit card
balance

$3,000
250

500
$6,780

$3,250
Net worth

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$3,530

National Saving and Its Components

Macroeconomists are interested
primarily in saving and wealth for the
country as a whole.
National saving includes the saving of
business firms, the government, and
households.
aggregate income =
consumption
Y = C + I + +Ggovernment
+ NX
expenditure

+ investment
spending

purchases of goods
and services
+ net exports

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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=YCG=I
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National Saving, 1998 2007

Since 1998, national saving has fluctuated
between 16% and 23% of GDP in Egypt, between
31% and 41% of GDP in Iran, and between 24%
and 32% of GDP in Morocco.

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11

Private Saving
Private saving is household plus
businesses saving
Household's total income is Y
Households pay taxes from this income
Government

transfer payments increase

household incomes

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
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12

Private Saving
Private saving is after-tax income less
consumption
SPRIVATE = Y T C
Private saving is done by households and
businesses
Household

saving or personal saving is done by

families and individuals
Business saving makes up the majority of
private saving in the US

Business saving is revenues less operating costs less

dividends to shareholders
Business saving can purchase new capital equipment
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13

Public Saving and National Saving

Public saving is the amount of the public
sector's income that is not spent on current
needs
Public

sector income is net taxes

Public sector spending on current needs is G

SPUBLIC = T G
National saving (S) is private savings plus
public savings
SPRIVATE + SPUBLIC = (Y T C) + (T G)
S=YCG
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14

The 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)

Budget surplus is public savings

Government

budget deficit is the

excess of government spending over
net tax collections

Budget
deficit is public dissaving
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15

Government Receipts and

Expenditures (in billions of local
currency)

Country

Receipts

Algeria
Bahrain
Egypt
Iran

3,672
1.75
289
829,930

2009
Expenditure
s
4,214
2.43
361
884,798

Iraq
Jordan
Kuwait
Lebanon
Libya
Morocco
Oman
Qatar
Saudi
Arabia
Sudan
Syria
Tunisia
UAE
Yemen

59,905
4.47
19
12,802
49
194
7.22
155
594

76,799
5.91
13
17,030
42
213
6.87
102
628

-16,894
-1.44
6
-4,228
7
-19
0.35
53
-34

20
534
17.24
212
1,275

26
667
18.11
264
1,795

-6
-133
-0.87
-52
-520

Differenc
e
-542
-0.69
-72
-54,868

2010
Receipt Expenditure Differenc
s
s
e
4,592
5,779
-1,187
2.08
2.52
-0.44
300
398
-98
965,95
952,059
13,900
9
74,782
88,741
-13,959
4.49
5.65
-1.16
20
15
5
14,224
19,333
-5,109
58
45
13
191
217
-26
9.12
7.73
1.39
169
114
55
727
696
31
27
593
18.46
263
1,836

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33
713
20.18
249
2,210

-6
-120
-1.73
14
-374
16

Three Components of Egyptian

National Savings, 1996 2008

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17

Three Components of Moroccan

National Savings, 1996 2007

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18

Why Do People Save?

1.Life-cycle saving is to meet
long-term objectives
Retirement

Purchase a

home
Children's college attendance

2.Precautionary saving is for

protection against setbacks
Loss

of job
emergency

Medical

3.Bequest saving is to leave an

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Economic Naturalist: Household

Saving in Japan
After World War II, households increased their
saving rates were to 15 25%
Declined

after 1990

Life-cycle motives are important

Long

life expectancy
Retire relatively early; long retirement period
Age structure of the population favored saving
Housing prices and down payment requirements were
very high

Property values decreased after 1990

Bequest saving matters in return for support and

attention during later years
Precautionary saving is low due to job security
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Saving and the Real Interest Rate

Savings often take the form of financial
assets that pay a return
Interest-bearing
Savings

checking

Bonds

CDs
Mutual funds
Stocks

The real interest rate (r) is the

nominal interest rate (i) minus the rate
of inflation ()
The

increase in purchasing power from a

financial asset
Marginal benefit of the extra saving
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21

Thrifts and Spends Families

Two otherwise identical families have
different savings rates
Higher

savings reduces current consumption

Thrifts consume $32,000 in 1980 and Spends

consume $38,000
Spends
Thrifts get more
Savings
unearned income
5%
Rage

Thrifts income growsStart Date

faster
End Date
From

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20%

1980

1980

2015

2015

1995 on, Thrifts Real Income

$40,000
consume more than
Spends
Real
Interest

Thrifts

8%

$40,00
0
8%
22

Thrifts and Spends Families

By 2015
Thrifts

consumption is $12,000 more than

Spends
Retirement savings is $385,000

Spends accumulated savings is $77,000

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23

Savings in Perspective
8% is lower than the return to mutual funds since
1980
Even 5% savings is higher than typical household
Many

have $5,000+ in credit card debt at high interest rates

Bottom line: High savings rate pays off in the long

run
If people are target savers, a high interest rate lowers
savings rate
To

get $25,000 in five years,

Save $4,309 per year at 5% OR
Save $3,723 per year at 10%

Data show higher real rates increase savings

modestly
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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
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Harith and the Lawn Mower

Harith's lawn care business plan
Cost

Interest on loan = 6%
Assume the mower can be resold for
$4,000

Net

of lawn mower = $4,000

revenue = $6,000 per summer

Taxes = 20%
Harith could earn $4,400 per summer
after tax working elsewhere

Cost Benefit Principle indicates

whether Harith should start the
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Harith and the Lawn Mower

Business plan analysis
Net revenue
$6,000
Less taxes (20%) $1,200
After tax revenue $4,800
Less opportunity cost $4,400
Equals VMP of lawnmower $400
Less interest (6%) $240
Equals net benefit $160

Harith should start the business

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Harith and the Lawn Mower

Business plan analysis
Interest rate is 12%
Net revenue
$6,000
Less taxes (20%) $1,200
After tax revenue $4,800
Less opportunity cost $4,400
Equals VMP of lawnmower $400
Less interest (12%) $480
Equals net benefit -$80

Harith should not start the business

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Harith and the Lawn Mower

Business plan analysis
Lawnmower price is $7,000
Net revenue
$6,000
Less taxes (20%) $1,200
After tax revenue $4,800
Less opportunity cost $4,400
Equals VMP of lawnmower $400
Less interest (6%) $420
Equals net benefit -$20

Harith should not start the business

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Harith and the Lawn Mower

Business plan analysis
Tax rate is 25%
Net revenue
$6,000
Less taxes (25%) $1,500
After tax revenue $4,500
Less opportunity cost $4,400
Equals VMP of lawnmower $100
Less interest (6%) $240
Equals net benefit -$140

Harith should not start the business

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Harith and the Lawn Mower

Business plan analysis
Net revenue is $5,500
Net revenue
$5,500
Less taxes (20%) $1,100
After tax revenue $4,400
Less opportunity cost $4,400
Equals VMP of lawnmower $0
Less interest (6%) $240
Equals net benefit -$240

Harith should not start the business

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The Investment Decision

Two important costs
Price

of the capital goods

Real interest rates

Opportunity cost of the investment

Value of the marginal product of the

capital is its benefit
Net

of operating and maintenance expenses

and of taxes on revenues generated
Technical innovation increases benefits
Lower taxes increase benefits
Higher price of the output increases benefits
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Economic Naturalist: Investment in

Computers, 1960 - 2007
Computer technology may have driven
increases in productivity since 1995

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Economic Naturalist: Investment in

Computers
Computer investment increased
faster than other capital goods
Unique attributes of computers are
The

declining price of computing

power

Computing power per dollar doubles

every 18 months

The

increase in the value of the

marginal product of computers
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34

Saving, Investment, and Financial

Markets
Supply of savings (S) is the amount of
savings supplied (lent) at each possible
real interest rate (r)
The

quantity supplied increases as r increases

Supplied by households, firms, and the
government

Demand for investment (I) is the

amount of savings demanded (borrowed)
at each possible real interest rate
The

quantity demanded is inversely related to

r
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Financial Market

Saving S
Real interest rate (%)

Equilibrium interest
rate equates the
amount of saving with
the investment funds
demanded
If r is above
equilibrium, there is
a surplus of savings
If r is below
equilibrium, there is
a shortage of savings

r
Investment I

S, I
Saving and investment

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Financial Markets Are 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

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37

Real interest rate (%)

Technological Improvement

r'
r

New technology
S
raises marginal
productivity of
capital
F
Increases the
E
demand for
investment funds
I'
I
Movement up the
savings supply
curve
A A'
Higher interest rate
Saving and Investment
Higher level of
savings and
38
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Government Budget Deficit

Increases

Real interest rate (%)

S'

F
r'

r
I

A' A
Saving and investment

Government budget
deficit increases
Reduces national
saving
Movement up the
investment curve
Higher interest rate
Lower level of
savings and
investment
Private investment is
crowded out

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39

Increase National Saving

Policymakers know the benefits of
increased national saving rates
Reducing

government budget deficit would

increase national saving and avoid crowding
out

Political problems

Increase

incentives for households

Federal consumption tax

Reduce taxes on dividends and investment income

Higher national saving rate leads to

greater investment in new capital goods
and a higher standard of living
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40