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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 save4. 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
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 Specific date Economic unit (business, household, etc.)
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Maria’s Balance Sheet, 1/1/2011
Assets LiabilitiesCash $80 Student loan $3,000Checking account 1,200 Credit card
balance250
Shares of stock 1,000Car (market value) 3,500Furniture (market value)
500
Total $6,280 $3,250Net worth $3,030
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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 ■ Spending Saving ■ 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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Maria’s Balance Sheet, 2/1/2011
Assets LiabilitiesCash $80 Student loan $3,000Checking account 1,200 Credit card
balance250
Shares of stock 1,500Car (market value) 3,500Furniture (market value)
500
Total $6,780 $3,250Net worth $3,530
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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.
Y = C + I + G + NX = aggregate income = consumption
expenditure= government
purchases of goods and services
= investment spending
= net exports
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Calculate National Savings
Assume NX = 0 for simplicityNational 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 needsS = Y – C – G
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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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Private Saving
Private saving is household plus businesses saving
Household's total income is YHouseholds 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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Private Saving
Private saving is after-tax income less consumption
SPRIVATE = Y – T – CPrivate 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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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 = Y – C – G
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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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Government Receipts and Expenditures (in billions of local
currency) 2009 2010
Country Receipts Expenditures
Difference
Receipts
Expenditures
Difference
Algeria 3,672 4,214 -542 4,592 5,779 -1,187Bahrain 1.75 2.43 -0.69 2.08 2.52 -0.44Egypt 289 361 -72 300 398 -98Iran 829,930 884,798 -54,868 965,95
9952,059 13,900
Iraq 59,905 76,799 -16,894 74,782 88,741 -13,959Jordan 4.47 5.91 -1.44 4.49 5.65 -1.16Kuwait 19 13 6 20 15 5
Lebanon 12,802 17,030 -4,228 14,224 19,333 -5,109Libya 49 42 7 58 45 13
Morocco 194 213 -19 191 217 -26Oman 7.22 6.87 0.35 9.12 7.73 1.39Qatar 155 102 53 169 114 55Saudi Arabia
594 628 -34 727 696 31
Sudan 20 26 -6 27 33 -6Syria 534 667 -133 593 713 -120
Tunisia 17.24 18.11 -0.87 18.46 20.18 -1.73UAE 212 264 -52 263 249 14
Yemen 1,275 1,795 -520 1,836 2,210 -374
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Three Components of Egyptian National Savings, 1996 – 2008
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Three Components of Moroccan National Savings, 1996 – 2007
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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 ■ Medical emergency
3.Bequest saving is to leave an inheritance Mainly higher income groups
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Household Saving in Japan
After World War II, household saving rates were 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; precautionary saving is low
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Saving and the Real Interest Rate
Savings often take the form of financial assets that pay a return Interest-bearing checking ■ Bonds Savings ■ 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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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 Thrifts get more
unearned incomeThrifts’ income grows
faster From 1995 on, Thrifts
consume more than Spends
Spends ThriftsSavings Rage 5% 20%
Start Date 1980 1980End Date 2015 2015Real Income $40,000 $40,00
0Real Interest 8% 8%
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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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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 of lawn mower = $4,000
Interest on loan = 6% Assume the mower can be resold for $4,000
Net revenue = $6,000 per summer Taxes = 20% Harith could earn $4,400 per summer after tax
working elsewhereCost – Benefit Principle indicates
whether Harith should start the business
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Harith and the Lawn Mower
Business plan analysis
Net revenue $6,000Less taxes (20%) $1,200Less opportunity cost $4,400Equals VMP of lawnmower $400Less interest (6%) $240Equals net benefit $160
Harith should 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 investmentValue 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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Investment in Computers, 1960 - 2007
Computer technology may have driven increases in productivity since 1995
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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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Saving, Investment, and Financial Markets
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
increasesDemand for investment (I) is the
amount of savings borrowed at each possible real interest rate The quantity demanded is inversely
related to r
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Financial Market
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 Saving and investment
Rea
l int
eres
t rat
e (%
)
Investment I
Saving S
S, I
r
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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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Technological Improvement
New technology raises marginal productivity of capital Increases the
demand for investment funds
Movement up the savings supply curve
Higher interest rate Higher level of
savings and investmentSaving and Investment
Rea
l int
eres
t rat
e (%
)
I
rE
S
r'
I'
F
A'
A
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Government Budget Deficit Increases
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
I
Saving and investment
Rea
l int
eres
t rat
e (%
) S
rEr'
F
S'
AA'
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Increase National Saving
Policymakers know the benefits of increased national saving rates Reducing government budget deficit
would increase national saving Political problems
Increase incentives for households Federal consumption tax Reduce taxes on dividends and investment
incomeHigher national saving rate leads to
greater investment in new capital goods and a higher standard of living