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Chapter 18: Saving, Capital
Formation, and Financial
Markets
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1
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 save
4. 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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2
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
Liabilities
Cash
$80
Checking account
1,200
Shares of stock
1,000
Car (market value)
3,500
Furniture (market value)
Total
Student loan
Credit card balance
$3,000
250
500
$6,280
$3,250
Net worth
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$3,030
4
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
■
 Saving
■
Spending
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
assets

Higher value for stock
 Capital
assets

gains increase the value of existing
losses decreases the value of existing
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
Liabilities
Cash
$80
Checking account
1,200
Shares of stock
1,500
Car (market value)
3,500
Furniture (market value)
Total
Student loan
Credit card balance
$3,000
250
500
$6,780
$3,250
Net worth
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$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
= investment spending
= government purchases of
goods and services
= net exports
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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
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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 Y
 Households 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 – C
 Private 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)
Country
Algeria
Bahrain
Egypt
Iran
Iraq
Jordan
Kuwait
Lebanon
Libya
Morocco
Oman
Qatar
Saudi Arabia
Sudan
Syria
Tunisia
UAE
Yemen
Receipts
3,672
1.75
289
829,930
59,905
4.47
19
12,802
49
194
7.22
155
594
20
534
17.24
212
1,275
2009
Expenditures
4,214
2.43
361
884,798
76,799
5.91
13
17,030
42
213
6.87
102
628
26
667
18.11
264
1,795
Difference
-542
-0.69
-72
-54,868
-16,894
-1.44
6
-4,228
7
-19
0.35
53
-34
-6
-133
-0.87
-52
-520
Receipts
4,592
2.08
300
965,959
74,782
4.49
20
14,224
58
191
9.12
169
727
27
593
18.46
263
1,836
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2010
Expenditures
5,779
2.52
398
952,059
88,741
5.65
15
19,333
45
217
7.73
114
696
33
713
20.18
249
2,210
Difference
-1,187
-0.44
-98
13,900
-13,959
-1.16
5
-5,109
13
-26
1.39
55
31
-6
-120
-1.73
14
-374
15
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
 Savings
 Mutual
checking
■
■
funds
■
Bonds
CDs
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
Spends
Thrifts
Thrifts get more
Savings Rage
5%
20%
unearned income
 Thrifts’ income grows
faster
 From
1995 on, Thrifts
consume more than
Spends
Start Date
1980
1980
End Date
2015
2015
Real Income
$40,000
$40,000
Real 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


Interest on loan = 6%
Assume the mower can be resold for $4,000
 Net


of lawn mower = $4,000
revenue = $6,000 per summer
Taxes = 20%
Harith could earn $4,400 per summer after tax
working elsewhere
Cost – Benefit Principle indicates whether
Harith should start the business
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Harith and the Lawn Mower
Business plan analysis
Net revenue
Less taxes (20%)
Less opportunity cost
Equals VMP of lawnmower
Less interest (6%)
Equals net benefit
$6,000
$1,200
$4,400
$400
$240
$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 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
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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 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
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Financial Market
Saving S
Real interest rate (%)
 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
r
Investment I
S, I
Saving and investment
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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
Real interest rate (%)
S
F
r'
E
r
I'
I
A A'
 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 investment
Saving and Investment
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Government Budget Deficit Increases
Real interest rate (%)
S'
S
F
r'
E
r
I
A' A
Saving and investment
 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
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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 income
 Higher national saving rate leads to greater
investment in new capital goods and a higher
standard of living
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