When you have completed your study of this chapter, you will be able to

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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

Define and explain the relationships among
capital, investment, wealth, and saving.
Explain how investment and saving decisions are
made and how these decisions interact in
financial markets to determine the real interest
rate.
Explain how government influences the real
interest rate, investment, and saving.
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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Physical capital
• The tools, instruments, machines, buildings, and
  other constructions that have been produced in
  the past and that are used to produce goods and
  services.
• Financial capital
• The funds that firms use to buy and operate
  physical capital.

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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Capital and Investment
• Gross investment
• The total amount spent on new capital goods.
• Net investment
• The change in the quantity of capitalequals
  gross investment minus depreciation.

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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Figure 24.1 illustrates the relationship between
  capital and investment.

On January 1, 2003,Toms DVD Burning, Inc. had
DVD recording machines valued at 3,000.
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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• During 2003, the value of Tom machines falls by
  2,000, depreciation.

• He spent 3,000 on new machinesgross
• investment.

Toms net investment was 1,000, so at the end of
2003,Tom had capital valued at 4,000.
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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Wealth and Saving
• Wealth
• The value of all the things that a person owns.
• Saving
• The amount of income that is not paid in taxes or
  spent on consumption goods and servicesadds to
  wealth.

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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Financial Markets
• Financial markets
• The collections of households, firms,
  governments, banks, and other financial
  institutions that lend and borrow.
• Global Financial Markets
• Lenders seek the highest possible real interest
  rate, and borrowers seek the lowest possible real
  interest rate in a single global financial market.

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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Financial markets are organized in four groups
• Stock markets
• Bond markets
• Short-term securities markets
• Loans markets

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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Stock Markets
• Stock
• A certificate of ownership and claim to the
  profits that a firm makes.
• Stock market
• A financial market in which shares of companies
  stocks are traded.

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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Bond Markets
• Bond
• A promise to pay specified sums of money on
  specified dates it is a debt for the issuer.
• Bond market
• A financial market in which bonds issued by firms
  and governments are traded.

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24.1 CAPITAL, INVESTMENT, WEALTH, SAVING

• Short-Term Securities Markets
• Short-term securities are commercial bills and
  Treasury billspromises by large firms and
  government to pay an agreed sum 90 days in the
  future.
• Loans Markets
• Banks and other financial institutions lower the
  cost of financing firms capital expenditures by
  accepting short-term deposits and making
  longer-term loans.

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24.2 INVESTMENT, SAVING, AND INTEREST

• Investment Demand
• Other things remaining the same, the higher the
  real interest rate, the smaller is the quantity
  of investment demanded and lower the real
  interest rate, the greater is the quantity
  investment demanded.

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24.2 INVESTMENT, SAVING, AND INTEREST

• The real interest rate is the opportunity cost of
  the funds used to finance the purchase of
  capital, and firms compare the real rate of
  interest with the rate of profit they expect to
  earn on their new capital.
• Firms invest only when they expect to earn a rate
  of profit that exceeds the real interest rate.
• The higher the real interest rate, the fewer
  projects that are profitable, so the smaller is
  the amount of investment demanded.

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24.2 INVESTMENT, SAVING, AND INTEREST

• Investment Demand Curve
• Investment demand
• The relationship between the quantity of
  investment demanded and the real interest rate,
  other things remaining the same.
• Investment demand is shown by an investment
  demand schedule or and investment demand curve.

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24.2 INVESTMENT, SAVING, AND INTEREST

• Figure 24.2 shows investment demand.

The table and figure show the quantity of
investment demanded at five real interest rates.
Points A through E on the investment demand curve
correspond to the rows in the table.
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24.2 INVESTMENT, SAVING, AND INTEREST

• Changes in Investment Demand
• When the expected rate of profit changes,
  investment demand changes.
• Other things remaining the same, the greater the
  expected profit from new capital, the greater is
  the amount of investment.

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24.2 INVESTMENT, SAVING, AND INTEREST

• The many influences on expected profit can be
  placed in three groups
• Objective influences such as the phase of the
  business cycle, technological change, and
  population growth
• Subjective influences summarized in the phrase
  animal spirits
• Contagion effects summarized in the phrase
  irrational exuberance

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24.2 INVESTMENT, SAVING, AND INTEREST

• Shifts of the Investment Demand Curve
• When investment demand changes, the investment
  demand curve shifts.

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24.2 INVESTMENT, SAVING, AND INTEREST

• Figure 24.3 shows changes in investment demand.

An increase in the expected profit increases
investment demand and shifts the investment
demand curve rightward to ID1.
A decrease in the expected profit decreases
investment demand and shifts the investment
demand curve leftward to ID2.
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24.2 INVESTMENT, SAVING, AND INTEREST

• Saving Supply
• The higher the real interest rate, the greater is
  the quantity of saving supplied, other things
  remaining the same.
• The lower the real interest rate, the smaller is
  the quantity of saving supplied, other things
  remaining the same.

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24.2 INVESTMENT, SAVING, AND INTEREST

• The real interest rate is the opportunity cost of
  consumption expenditure.
• A dollar spent is a dollar not saved, so the
  interest that could have been earned on that
  saving is forgone.

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24.2 INVESTMENT, SAVING, AND INTEREST

• Saving Supply Curve
• Saving supply
• The relationship between the quantity of saving
  supplied and the real interest rate, other things
  remaining the same.
• Saving supply is illustrated by a saving supply
  schedule or a saving supply curve.

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24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.4 shows saving supply.
The table and figure show the quantity of saving
supplied at five real interest rates.
Points A through E on the saving supply curve
correspond to the rows in the table.
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24.2 INVESTMENT, SAVING, AND INTEREST

• Changes in Saving Supply
• The three main factors that influence saving
  supply are
• Disposable income
• Buying power of net assets
• Expected future disposable income

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24.2 INVESTMENT, SAVING, AND INTEREST

• Disposable income
• Income earned minus net taxes.
• The greater a households disposable income,
  other things remaining the same, the greater is
  its saving.
• The greater the buying power of the net assets a
  household has accumulated, other things remaining
  the same, the less it will save.
• The higher a households expected future
  disposable income, other things remaining the
  same, the smaller is its saving.

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24.2 INVESTMENT, SAVING, AND INTEREST

• Shifts of the Saving Supply Curve
• Along the saving supply curve, all the influences
  on saving other than the real interest rate
  remain the same.
• A change in any of these influences on saving
  changes saving supply and shifts the saving
  supply curve.

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24.2 INVESTMENT, SAVING, AND INTEREST

• Figure 24.5 shows a change in saving supply.

The saving supply curve shifts rightward from SS0
to SS1 if

• Disposable income increases

• The buying power of net assets decreases

• Expected future disposable income decreases

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24.2 INVESTMENT, SAVING, AND INTEREST
The saving supply curve shifts leftward from SS0
to SS2 if

• Disposable income decreases

• The buying power of net assets increases

• Expected future disposable income increases

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24.2 INVESTMENT, SAVING, AND INTEREST

• Financial Market Equilibrium
• Figure 24.6 shows how the real interest rate is
  determined.

• ID is the investment demand curve
• SS is the saving supply curve

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24.2 INVESTMENT, SAVING, AND INTEREST
1. If the real interest rate is 8 percent a year,
the quantity of investment demanded is less than
the quantity of saving supplied.
2. If the real interest rate is 4 percent a year,
the quantity of investment demanded exceeds the
quantity of saving supplied.
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24.2 INVESTMENT, SAVING, AND INTEREST
3. When the real interest rate is 6 percent a
year, the quantity of investment demanded equals
the quantity of saving supplied.
There is neither a shortage nor a surplus of
saving, and the real interest rate is at its
equilibrium level.
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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• Government Budget and Government Saving

GDP is the sum of consumption expenditure, C
investment, I government purchases, G and net
exports, NX. In the global economy, net exports
are zero, so for the world as a whole Y C I
G
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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• GDP equals total income, which is the sum of
  consumption expenditure, saving, S, and net
  taxes, NT. So
• Y C S NT
• By combining these two ways of looking at GDP,
  you can see that
• C I G C S NT

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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• Because consumption is on both sides of this
  equation, we can subtract C and simplify the
  equation to
• I G S NT
• Now subtract government purchases from both sides
  of this equation to obtain
• I S (NT G)
• This equation tells us that investment is
  financed by private saving and government saving,
  NT G.
• Government saving, NT G, is also the government
  budget surplus.

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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• Total saving equals private saving plus
  government saving.
• So when the government has a budget surplus, it
  contributes toward financing investment.
• But when the government has a budget deficit, it
  competes with businesses for private saving and
  decreases the amount available for investment.

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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• Effect of Government Saving
• A government budget surplus increases total
  saving supply.
• To find total saving supply, we must add the
  government budget surplus to private saving
  supply.
• An increase in saving supply brings a lower
  interest rate, which decreases the quantity of
  private saving supplied and increases the
  quantity of investment.

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24.3 GOVERNMENT IN THE FINANCIAL MARKET
Figure 24.7 shows the effects of government
saving.
With balanced government budgets, the real
interest rate is 6 percent a year and investment
equals saving at 10 trillion a year.
1. A government budget surplus of 2 trillion is
added to private saving to determine the saving
supply curve SS.
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24.3 GOVERNMENT IN THE FINANCIAL MARKET
2. The real interest rate falls to 4 percent a
year.
3. Private saving decreases to 9 trillion.
4. Total saving and investment increase to 11
trillion.
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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• Government Deficit and Crowding Out
• A government budget deficit works in the opposite
  way to the surplus. It decreases total saving.
• To find total saving, subtract the government
  budget deficit from private saving.
• A decrease in total saving brings a higher
  interest rate, which increases the quantity of
  private saving supplied but decreases investment
  in a crowding-out effect.

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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• Crowding-out effect
• The tendency for a government budget deficit to
  decrease investment.

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24.3 GOVERNMENT IN THE FINANCIAL MARKET
Figure 24.8 shows a crowding-out effect.
With balanced government budgets, the real
interest rate is 6 percent a year and investment
equals saving at 10 trillion a year.
1. A government budget deficit is negative
government saving (dissaving). Subtract the
government deficit from private saving to
determine the saving supply curve SS.
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24.3 GOVERNMENT IN THE FINANCIAL MARKET
2. The real interest rate rises to 8 percent a
year,
3. Private saving increases to 11 trillion, and
4. Total saving and investment decrease to 9
trillion. Investment is crowded out.
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24.3 GOVERNMENT IN THE FINANCIAL MARKET

• The Ricardo-Barro Effect
• The proposition that a government budget deficit
  has no effect on the real interest rate or
  investment.
• The Ricardo-Barro effect operates if private
  saving supply changes and the private saving
  supply curve shifts to offset any change in
  government saving, so that the total saving
  supply is unchanged when the government budget
  changes.
• Most economists regard this outcome unlikely.