1. Topic 06
Saving, Capital
Formation, and
Financial Markets
14-1

2. Learning Objectives
1. Explain the relationship between savings and
wealth
2. Identify and apply the components of national
saving
3. Discuss the reasons why people save
4. Discuss the reasons why firms choose to invest
in capital rather than financial assets
5. Analyze financial markets using the tools of
supply and demand
15-2

3. Declining US Saving Rate
• Household savings declined since mid 1980s
– 3.0% of disposable income in 2007
• US rates low compared to other countries
• Low household savings rates will have long-run
consequences
– Can be offset by savings in businesses or
government
• National savings has not declined significantly
– Savings picture is less dire than household savings
suggests
15-3

4. US Household Saving Rate,
1960 - 2009
15-4

5. Savings and Wealth
• Saving is current income minus spending on
current needs
– The saving rate is saving divided by income
• Wealth is the value of assets minus liabilities
– Assets are anything of value that one owns
– Liabilities are the debts one owes
– The balance sheet is a list of an economic unit’s
assets and liabilities
• Specific date
• Economic unit (business, household, etc.)
15-5

6. Individual Balance Sheet, 1/1/11
Assets Liabilities
Cash $80 Student loan $3,000
Checking account 1,200 Credit card balance 250
Shares of stock 1,000
Car (market value) 3,500
Furniture (market value) 500
Total $6,280 $3,250
Net worth $3,030
15-6

7. Flow Values and Stock Values
• A flow value is defined per unit of time
– Income ■ Spending
– Saving ■ Wage
• A stock value is defined at a point in time
– Wealth ■ Debt
• The flow of savings 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
15-7

8. 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
15-8

9. US Stock Prices, 1960 - 2004
15-9

10. The Bull Market of the 1990s
• Stock ownership increased
– Direct purchases
– Mutual funds
– Pension and retirement funds
• Stock prices rose rapidly
– Capital gains on stocks increased household wealth
• May have decreased household savings
• Stock market declined, 2000 – 2002
– Household savings remained low
– Value of privately-owned homes increased rapidly
15-10

11. National Savings
• Macroeconomics studies total savings in the
economy
– Household savings is one component
– Business and government savings are other parts
• Start with the definition of production and income
for the economy
Y = C + I + G + NX
Y = aggregate income
C = consumption G = government
expenditure purchases of goods
and services
I = investment spending NX = net exports
15-11

12. 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=Y–C–G
15-12

13. National Savings, 1960 - 2009
• Since 1960, national savings rate has been 11 –
18%
– Less volatile than household savings
15-13

14. Private Saving
• Private saving is household plus business saving
• Household's total income is Y
• Households pay taxes (T) from this income
– Government transfer payments increase household
income
• 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
15-14

15. 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 savings makes up the majority of private
saving in the US
• Business savings is revenues less operating costs
less dividends to shareholders
• Business savings can purchase new capital
equipment
15-15

16. Public Saving and National
Saving
• Public saving is the amount of the public sector's income
that is not spend 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
15-16

17. 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 dissavings
15-17

18. Government Saving
Federal Government (billions of dollars) 2000
Receipts $2,057.1
Expenditures 1,871.9
State and Local Governments
Receipts 1,322.6
Expenditures 1,281.3
Federal Government (billions of dollars) 2009
Receipts $2,224.9
Expenditures 3,451.3
State and Local Governments
Receipts 1,995.5
Expenditures 2,014.6
15-18

19. From Surplus to Deficit
• Three reasons for change in government budget
– Government receipts decreased during the
recessions of 2001 and 2007-2009
• Lower income during recession means lower taxes
– Tax reductions during the first Bush term
– Government spending increased
• Wars in Iraq and Afghanistan
• Homeland Security
15-19

20. National Saving, 1960 - 2009
15-20

21. Low Household Savings
• National savings determines a country's ability to
invest in new capital goods
– Household savings has been low
– Business saving has been significant
– In the 1990s, government saving increased
• From 1960 to 2002, national saving rate was
fairly stable
• Since 2002, government dissaving has
contributed to a decline in the US national
saving rate
15-21

22. Low Household Savings
• Low household saving rate is a symptom of
growing inequality of wealth
– High-income households save and earn income on
their wealth
• Shareholders in businesses so they have a claim on
business savings
– Increased value of homes
– Low-income households have little savings and
wealth
• Life savings as little as $5,000
• Little protection against setbacks
15-22

23. Three Reasons for Household
Saving
1. Life-cycle saving is to meet long-term
objectives
– Retirement ■ Purchase a home
– Children's college attendance
1. Precautionary saving is for protection against
setbacks
– Loss of job ■ Medical emergency
1. Bequest saving is to leave an inheritance
– Mainly higher income groups
15-23

24. 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 savings matters; precautionary savings is
low
15-24

25. 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 (π)
– The increase in purchasing power from a financial
asset
– Marginal benefit of the extra saving
15-25

26. Thrifts and Spends
• 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
• Thrifts get more
unearned income Savings Rage 5% 20%
Start Date 1980 1980
• Thrift's income grows
End Date 2015 2015
faster Real Income $40,000 $40,000
– From 1995 on, Thrifts Real Interest 8% 8%
consume more than
Spends
15-26

27. Thrifts and Spends
• By 2015
– Spend’s consumption is $12,000 more than Thrift's
– Retirement savings is $385,000
• Spend's accumulated savings is $77,000
15-27

28. Savings in Perspective
• 8% is lower than the return to mutual funds since 1980
• 20% 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
15-28

29. Maximize Lifetime Well Being
• Psychologists suggest individual self-control
may be too weak to produce rational outcomes
– Smoking, obesity, gambling, and spending
• Devices to support savings
– Make savings automatic and withdrawals costly
• Penalties for early withdrawal of IRA funds
• Easy borrowing supports high levels of current
spending
– Credit cards
– Home equity loans
15-29

30. Explaining US Household
Savings Rate
• Savings rate may be depressed by
– Social Security, Medicare, and other government
programs for the elderly
– Mortgages with small or no down payment
– Confidence in a prosperous future
– Increasing value of stocks and growing home
values
– Readily available home equity loans
– Demonstration effects and status goods
15-30

31. 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
15-31

32. Larry and the Lawn Mower
• Larry'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%
• Larry could earn $4,400 per summer after tax
working elsewhere
• Cost – Benefit Principle indicates whether Larry
should start the business
15-32

33. Larry and the Lawn Mower
• Business plan analysis
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
• Larry should start the business
15-33

34. 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
15-34

35. Investment in Computers
• Purchases of new computers and software is
more than 2.5% of GDP
– 24% of all private nonresidential investment
• 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
15-35

36. Investment in Computers, 1960-2009
• Computer technology may have driven increases in
productivity since 1995
15-36

37. 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 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
15-37

38. 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 Investment I
surplus of savings
• If r is below S, I
equilibrium, there is a Saving and investment
shortage of savings
15-38

39. 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
15-39

40. Technological Improvement
• New technology
S
raises marginal
Real interest rate (%)
productivity of capital
F – Increases the
r'
E demand for
r investment funds
I' – Movement up the
I
savings supply curve
– Higher interest rate
– Higher level of
Saving and Investment savings and
investment
15-40

41. Government Budget Deficit
Increases
S' • Government budget
S
deficit increases
Real interest rate (%)
F
• Reduces national saving
r' E • Movement up the
r investment curve
I • Higher interest rate
• Lower level of savings
and investment
• Private investment is
Saving and investment crowded out
15-41

42. 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 income
• Higher national saving rate leads to greater
investment in new capital goods and a higher
standard of living
15-42

43. Saving, Capital Formation, and
Financial Markets
Low
Financial
Household
Markets
Saving
Investment
and Capital
Private
National Saving
Saving
Wealth Public Saving
Interest Rate
Capital Gains Government
and Losses Budget
15-43