Principles of

Economics

Saving, Capital Formation,

and Financial Markets
Chapter 19
 Learning Objectives
1. Explain the relationship between savings
and wealth
2. Identify and apply the components of
national saving
3. Discuss the reasons why households and
nations save
4. Differentiate between bonds and stocks
5. Analyze financial markets using IS curves

19-2
 Savings and Wealth
• Saving is the amount of our income that is not spent.
• Wealth (net worth) is the value of assets minus liabilities
– Assets are anything of value that one owns
– Liabilities are the debts one owes
• More saving increases wealth
– Every dollar a person saves adds to his wealth
• The saving rate =

– If your income is $5,000 , and you save $1,000, then your

saving rate is: x100 = 20%.

19-3
 National Savings
– National saving (S) is:
– private: savings done by households and businesses (Sprivate)
– public: savings by government (Spublic)
National saving (S) = Private Saving + Public Saving

• The income equation is Y = C + I + G + NX

Y = aggregate income, current income, output or GDP
C = consumption expenditure G = government spending

I = investment spending NX = net exports

If NX =0, then Y = C + I + G
19-4
 Calculation of National Savings

• Our national income is divided between saving (S)

and current spending (C+G).
– Current spending is mostly consumption (C) and
government (G) spending.
– EXCLUDE investment spending (I)
• Then
Y=C + I +G (1)
 Y = [C + G] + S (2)
• National saving (S) is current income (Y) less
current spending [C + G]
S=Y–C–G (3) 19-5
• National Income Distribution:
• Income – Taxes = Consumption +
Saving i.e.
• Y–T=C+S
• Gross Domestic Product
• GDP = Consumption + Investment +
Government Expenditure + Net Exports
• GDP = C + I + G + NX
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• Y=T+C +S
• GDP = C + I + G + NX
• Y = GDP =>
• C + T + S = C + I + G + NX =>
• T + S = I + G + NX
• (S – I) = (G – T) + NX
• (I – S) = (T – G) + (-NX)
• I = (T – G) + (S – NX)
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reserved.
 National Savings, 1960 - 2013

• Since 1960, national savings rate has been 9 – 19%

19-8
 National saving:
private and public saving
Private saving Public saving
• Household's income is Y. • Government’s revenues (T) that are not
• Households pay net taxes (T) spent on current needs (G)
from Y. – Government makes transfer
• Private saving is after-tax payments (like pensions), and
income less consumption pays interest to bondholders, both
increase households’ income
• SPRIVATE = Y – T – C
SPUBLIC = T – G
T (net taxes ) = Gross Taxes – Government Transfer

SPRIVATE = Y – T + Transfers – C , SPUBLIC = T – G

=Y–T-C

National saving (S) = private saving + public saving

SPRIVATE + SPUBLIC = (Y – T – C) + (T – G)
S = Y–C–G
19-9
 The Government Budget: T and G
• Balanced budget occurs when government spending (G) equals net
tax receipts (T)
(T – G) is equal to 0.

• Budget surplus is when net taxes is higher than spending.

Budget surplus is public savings
(T – G) is greater than 0.
– Government use surplus to pay back debt and interest on debt

• Budget deficit is when net taxes is lower than spending.

(T – G) is lower than 0.

– Governments issue bonds to cover the deficit (government

increases national debt)
19-10
 Reasons for Saving
Household:
1. Life-cycle saving is to meet long-term objectives, such as
• Retirement
• Purchase a house
• Paying Children's high education
2. Precautionary saving is for protection against in expected events
(emergencies)
• Loss of job
• Medical emergency
3. Bequest saving is to leave an inheritance
Nations (I = S)
• Nations save to finance producing new capital goods
– This will promote growth and higher standard living in the future

19-11
 Saving and the Real Interest Rate

• Savings often take the form of financial

assets that pay a “real” return.
– Examples include: Savings accounts, bonds,
stocks
– In the UAE, many people buy shares in Coop
and Etihad
• Real return may be measured by the real
interest rate (r)
– r is the nominal interest rate (i) minus inflation
rate ()
19-12
 Bonds
• A bond is a legal promise to repay a debt
• Each bond specifies
– Principal amount: the amount originally lent
– Maturity date: the date when the principal amount will be
repaid
– Coupon rate, the interest rate that is applied to the principal
to determine the coupon payments
• Coupon payments, the periodic interest payments to the bondholder
• If the principal amount of a bond is $1,000,000, the
coupon rate is 7%, then the annual coupon payment
made to the holder of the bond is $70,000 = $1,000,000
X 7%.
19-13
 Stocks

• A share of stock is a claim to partial

ownership of a firm.
– Receive dividends, a periodic payment
determined by management (divided is NOT profit)
– Receive capital gains if the price of the stock
increases
• Prices are determined in the stock market,
reflecting supply and demand
• Wealth changes when the value of your assets (eg. stocks) change
– Capital gains (losses) increase (decrease) the value of existing
assets
19-14
 Example
• You bought a share of Nike at $70.61 on
21/05/2018, and you sold at $83.28 after one year.
Over the holding period, you received dividend of
$0.84 per share.
• Calculate the capital gain?
$83.28 – $70.61 = $ 12.67
• Calculate the total return. (capital gain + div)
• $12.67 + $0.84 = $13.51
• Calculate the rate of return? (return/ purchase price)
• $13.51 / $70.61 = 19.13%
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 Investment, Capital Formation and financial system

• Investment (I, or capital formation) is the creation of

new capital goods and housing
Equation 1: Y = C + I + G
Equation 2: Y = C + S + G
C+I+G=C+S+GS=I
 Saving = Investment spending
• At the national level, higher saving rates lead to greater
investment and higher standards of living.
• Banks and financial markets transfer funds from savers
(S) to borrowers with productive investment
opportunities (I)
– Corporations issue stocks and bonds to finance their balance sheet
19-16
 IS curves

• 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
• Demand for investment (I) is the amount of
savings borrowed at each possible real interest
rate
• The quantity demanded is inversely related to r

19-17
• Y = C(Y) + S(Y) + T(Y)
• GDP = C(Y) + I(r) + G + NX
• Y = GDP => S(Y) + T(Y) = I(r) + G + NX
• As r falls, I(r) increses [i.e. dI(r)/dr < 0]
• I(r) + G + NX increases => S(Y) + T(Y)
increases => Y increases
• interest rate decreases => investment
increases => GPD (and Y) increases
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 Example

• C = 10 + 0.7Y; S(Y) = -10 + 0.3Y, T = 15

• I(r) = 20 – 18r; G = 20; NX = -5
• S(Y) + T = I(r) + G + NX 
• -10 + 0.3Y + 15 = 20 – 18r + 20 – 5 
• 0.3Y = 45 – 1.5r  Y = 45/0.3 – (18/0.3)r
• If r = 0.05, Y = 150 – 60(0.05) = 147
• If r = 0.01, Y = 150 – 60(0.01) = 149.04

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reserved.
• C = 10 + 0.7Y; T = 15; I(r) = 20 – 18r; G
= 20; NX = -5
• Y = C(Y) + I(r) + G + NX
• Find Y, when r = 0.05
• Find Y, when r = 0.01

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reserved.
 Financial Market

• Equilibrium interest
Saving S
rate equates the

Real interest rate (%)

amount of saving with
the investment funds
demanded r
• If r is above equilibrium,
there is a surplus of savings Investment I
• If r is below equilibrium,
there is a shortage of
S, I
savings
Saving and investment
19-21