Saving and Capital Formation

1
Saving and Capital Formation
2
Introduction

• Motives for Saving
• To meet future expenditures
• Protect against an economic emergency
• Produce capital goods

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Household Saving Rate in the United States, 1960
- 2004
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Savings and Wealth

• Saving
• Current income minus spending on current needs
• Saving Rate
• Saving divided by income

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Savings and Wealth

• Wealth
• The value of assets minus liabilities
• Assets
• Anything of value that one owns

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Savings and Wealth

• Liabilities
• The debts one owes
• Balance Sheet
• A list of an economic units assets and
  liabilities on a specific date

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Consuelos Balance Sheeton January 1, 2005
Liabilities Student loan 3,000 Credit card
balance 250
______ 3,250 Net worth 3,030
Assets Cash 80 Checking account 1,200 Shares of
stock 1,000 Car (market value) 3,500 Furniture
(market value) 500 Total 6,280

• Earnings (300/wk) - Expenditures (280/wk)
  Saving (20/wk)
• Saving Rate 20/300 6.7
• Wealth (3,030) Assets (6,280) - Liabilities
  (3,250)

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Savings and Wealth

• Flow
• A measure that is defined per unit of time
• Stock
• A measure that is defined at a point in time

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Savings and Wealth

• Stocks and Flows
• Saving is a flow and is defined per unit of time
  (saving/week).
• Wealth is a stock and is defined at a point in
  time (wealth on a given date).
• Flow is the rate of change in the stock.
• Every dollar a person saves adds to their wealth.

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Savings and Wealth

• Example
• The link between saving and wealth
• Consuelos saving (20) is a flow that increases
  her assets or reduces her liabilities by 20 and
  increases her wealth (stock) by 20.

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Savings and Wealth

• Capital Gains
• Increases in the value of existing assets
• Capital Losses
• Decreases in the value of existing assets

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Consuelos Balance Sheet on February 1, 2005,
after an Increase in the Value of Her Stocks
Liabilities Student loan 3,000 Credit card
balance 250
______ 3,250 Net worth 3,530
Assets Cash 80 Checking account 1,200 Shares of
stock 1,500 Car (market value) 3,500 Furniture
(market value) 500 Total 6,780

• Capital Gains
• Stock value increases from 1,000 to 1,500
• Assets increase by 500
• Wealth increases by 500
• Capital Loss
• Reduces wealth

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Savings and Wealth

• Change in Wealth equals
• Saving Capital gains - Capital loss

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The Bull Market of the 1990s

• Observations
• During the 1990s, household saving fell while
  wealth rose
• Households acquired stocks in the 1990s and stock
  prices rose
• 2000 - 2001 the fall in stock prices was offset
  by rising home values

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Why Do People Save?

• Life-Cycle Saving
• Saving to meet long-term objectives, such as
  retirement, college attendance, or the purchase
  of a home

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Why Do People Save?

• Precautionary Saving
• Saving for protection against unexpected
  setbacks, such as the loss of a job or a medical
  emergency

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Why Do People Save?

• Bequest Saving
• Saving done for the purpose of leaving an
  inheritance

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Why Do People Save?

• Economic Naturalist
• Household Saving in Japan
• Life-cycle motive
• Long life expectancy
• Retire relatively early
• Housing prices are very high and down payment
  requirements are also high

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Why Do People Save?

• Economic Naturalist
• Household Saving in Japan Bequest motive
• Parents, who live with their children after
  retirement, leave a large inheritance

20
Why Do People Save?

• Economic Naturalist
• Household Saving in Japan
• Precautionary motive
• Very high job security reduces the precautionary
  motive

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Why Do People Save?

• Saving and the Real Interest Rate
• The higher the real rate the greater the reward
  from saving.

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Why Do People Save?

• Example
• By how much does a high savings rate enhance a
  familys future living standard?

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Consumption Trajectories of the Thrifts and the
Spends

• Spends save 5 Thrifts save 20
• Real earnings for both 40,000
• Both invest in mutual funds with a real yield of
  8
• By 2015, Thrifts consume 55, 774 and Spends
  consume 43,698
• By 2015, Thrifts savings is 385,000 and Spends
  savings is 77,000

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Why Do People Save?

• Observation
• If people are target savers, a high real interest
  rate may reduce saving.

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Why Do People Save?

• Saving, Self-Control, and Demonstration Effects
• Self-Control Hypothesis
• People lack the self-control to save

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Why Do People Save?

• Saving, Self-Control, and Demonstration Effects
• Techniques to offset the lack of self-control and
  increase savings
• Payroll savings
• Retirement accounts with limited withdrawals

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Why Do People Save?

• Saving, Self-Control, and Demonstration Effects
• Factors that may reduce self-control and savings
• Home equity loans
• Credit cards with high borrowing limits

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Why Do People Save?

• Saving, Self-Control, and Demonstration Effects
• Demonstration effects
• People use spending by others to measure the
  adequacy of their own spending.
• When satisfaction depends on relative living
  standards, an upward spiral of spending can
  occur, which reduces savings.

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Why Do People Save?

• Economic Naturalist
• Why do U.S. households save so little?
• Life-cycle motive
• Social security and Medicare
• Low down payment requirements for home mortgages

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Why Do People Save?

• Economic Naturalist
• Why do U.S. households save so little?
• Precautionary motive
• Stable economic performance
• Strong capital gains

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Why Do People Save?

• Economic Naturalist
• Why do U.S. households save so little?
• Self-control effect
• U.S. financial markets may have made it too
  easy to borrow

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Why Do People Save?

• Economic Naturalist
• Why do U.S. households save so little?
• Demonstration effect
• Increased real wage inequality

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National Saving and Its Components

• The Measurement of National Saving
• Real income or expenditures (Y) Consumption (C)
  Investment (I) Government (G) Net exports
  (NX)
• Assume NX 0, therefore
• Y C I G
• Saving Y - spending on current needs

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National Saving and Its Components

• The Measurement of National Saving
• Determining spending on current needs
• I spending on capital goods and residential
  housing
• C includes durable goods which may be current and
  future needs
• G may also include current and future needs
• Assume that all C and G are current need
  expenditures

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National Saving and Its Components

• The Measurement of National Saving
• National Saving (S) Y - C - G

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U.S. National SavingRate, 1960 - 2004
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National Saving and Its Components

• Private and Public Components of National Saving
• National Saving (S) Y - C - G
• T (net taxes) private-sector tax payments -
  transfer payments and interest payments
• Private saving Sprivate Y - T - C
• Public saving Spublic T - G

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National Saving and Its Components

• Private and Public Components of National Saving
• Two components of private saving
  (Sprivate Y - T - C)
• Household (personal) saving
• Business saving

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National Saving and Its Components

• Private and Public Components of National Saving
• Spublic T - G
• Includes
• Federal
• State
• Local

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National Saving and Its Components

• Private and Public Components of National Saving
• S (Y - T - C) (T - G)
• S Sprivate Spublic
• National Saving (S) is composed of saving by
  households, businesses, and government (federal,
  state, and local)

Private
Public
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National Saving and Its Components

• Government Budget Deficit
• The excess of government spending over tax
  collections (G - T)

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National Saving and Its Components

• Government Budget Surplus
• The excess of government tax collections over
  government spending (T - G)
• The government budget surplus equals public saving

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National Saving and Its Components

• Public Saving and the Government Budget
• 2000 Spublic T - G
• Federal 189.4 2,053.8 - 1,864.4
• State local 50.0 1,319.5 - 1,269.5
• Spublic 239.4 3,373.3 - 3,133.9

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National Saving and Its Components

• Public Saving and the Government Budget
• 2004 Spublic T - G
• Federal -369.4 1,971.8 - 2,341.2
• State local 17.5 1,585.3 - 1,567.8
• Spublic -358.0 3,551.0 - 3,909.0

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The Three Components of National Saving, 1960-
2004
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National Saving and Its Components

• Is Low Household Saving a Problem?
• Observations Macroeconomic Perspective
• National saving, not household saving, determines
  the capacity of the economy to invest in new
  capital goods.

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National Saving and Its Components

• Is Low Household Saving a Problem?
• Observations Macroeconomic Perspective
• National saving has been reasonably stable
  despite the decline in household saving.

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National Saving and Its Components

• Is Low Household Saving a Problem?
• Observations Macroeconomic Perspective
• National saving, while relatively low, has been
  sufficient to allow the U.S. to become one of the
  worlds most productive economies.

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National Saving and Its Components

• Is Low Household Saving a Problem?
• Observations Microeconomic Perspective
• The low household saving rate signals a problem
  of growing inequality in wealth among U.S.
  households.

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Investment andCapital Formation

• Investment
• Investment -- the creation of new capital goods
  and housing -- is necessary to increase average
  labor productivity.
• National saving is the source of funding for
  investment.

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Investment andCapital Formation

• Investment
• Investment spending is undertaken if it is
  expected to be profitable (i.e., the benefit, or
  value of marginal product, exceeds the cost of
  the investment)

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Investment andCapital Formation

• Example
• Should Larry buy a riding lawn mower?
• Cost of lawn mower 4,000
• Interest on loan 6
• Net revenue 6,000
• Taxes 20
• Larry could earn 4,400 after tax elsewhere
• Assume the mower can be resold for 4,000

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Investment andCapital Formation

• Example
• Should Larry buy a riding lawn mower?
• Net revenue 6,000
• Less Taxes (20) 1,200
• Less Opportunity Cost 4,400
• Equals VMP of lawnmower 400
• Less Interest (6) 240
• Equals Net Benefit 160

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Investment andCapital Formation

• Factors that Determine the Investment Decision
• Measuring the costs
• Real interest rate (opportunity cost)
• Price of capital goods

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Investment andCapital Formation

• Factors that Determine the Investment Decision
• Measuring the benefits
• Value of marginal product
• Operating expense
• Maintenance expense
• Tax liability
• Influenced by the relative price of the good or
  service produced by the capital

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Investment andCapital Formation

• Economic Naturalist
• Why has investment in computers increased by so
  much in recent decades?

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Investment in Computers and Software, 1960 - 2004
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Saving, Investment, and Financial Markets

• Supply of Savings (S)
• The quantity supplied of saving is directly
  related to the real interest rate (r)
• Demand for Saving (I)
• The quantity demanded for saving is inversely
  related to r.

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Saving, Investment, and Financial Markets

• Market for Savings
• The market will determine the equilibrium (r).
• If r is above equilibrium, a surplus of savings
  will exist.
• If r is below equilibrium, a shortage of savings
  will exist.

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The Supply andDemand for Savings
Real interest rate ()
Saving and investment
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The Effect of a New Technology on National
Saving and Investment
S
E
Real interest rate ()
r
I
Saving and investment
62
The Effects of An Increase in the Government
Budget Deficit On National Saving and Investment
S
E
Real interest rate ()
r
I
Saving and investment
63
Saving, Investment, and Financial Markets

• Crowding Out
• The tendency of increased government deficits to
  reduce investment spending

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Saving, Investment, and Financial Markets

• Economic Naturalist
• How can we increase national saving?

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End of Chapter