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CHAPTER
10 -- KIS
Capital, Investment,
and Saving
Learning Objectives

Describe the growth and fluctuations of
investment and the capital stock

Describe the fluctuations in the real
interest rate

Explain how business investment
decisions are made
2
Learning Objectives (cont.)

Explain how household saving
decisions are made

Explain how investment and saving
interact to determine the real interest
rate
3
Learning Objectives (cont.)

Explain how government influences the
real interest rate, saving, and
investment

Explain how international borrowing and
lending are determined
4
Capital and Investment

Capital is the total quantity of plant,
equipment, buildings, and inventories.

Gross investment is the purchase of
new capital.
6
Capital and Investment

Depreciation is the wearing out and
scrapping of existing capital.

Net investment is gross investment
minus depreciation.
7
Capital and Investment

Private investment is business
investment plus investment in new
homes and addition to inventories.

Government investment is the part of
government purchases that creates
social infrastructure capital.
8
Investment and the
Capital Stock: 1970–1998
9
Investment
Year
Gross
Net
Invest- Depre- Investment
ciation ment
1996
1.3 T
0.8T
0.5 T
1997
1.5 T
0.9T
0.6 T
Firgures include government investment & dep.
Federal Reserve Bulletin, August 1998
11
Investment and the
Capital Stock: 1970–1998
12
Investment in the United States
and World: 1970–1998
14
Capital and Investment

Interest Rates
– The real interest rate, or return on capital,
is the nominal interest rate adjusted for
inflation.
• The nominal interest rate is the interest rate
expressed in terms of money.
• The real interest rate is approximately equal to
the nominal interest rate minus the inflation
rate.
17
The Real Interest Rate
18
Investment Decisions

Business investment decisions are
influenced by:
1) The expected profit rate
2) The real interest rate
21
Investment Decisions

The Expected Profit Rate
– The greater the expected profit rate from
new capital, the greater is the amount of
investment.
22
Investment Decisions

The Expected Profit Rate
– The net revenue from an investment in a
plant is equal to the total revenue from
sales minus the cost of labor and
materials.
– Expected profit is the net revenue minus
the cost of the plant.
– The expected profit rate is the expected
profit divided by the cost of the plant.
23
Investment Decisions

The Expected Profit Rate
– Three Major Factors Affecting the Expected
Profit Rate
1) The phase of the business cycle
2) Advances in technology
3) Taxes
24
Investment Decisions

The Real Interest Rate
– The lower the real interest rate, the greater
is the amount of investment.
– The opportunity cost of funds is the real
interest rate.
25
Investment Decisions

The Real Interest Rate
– If the real interest rate exceeds the
expected profit rate, firms should not invest
in new capital since they could earn more
by loaning the funds to other firms.
– More investments are profitable at low
interest rates, and less are profitable at
high interest rates.
26
Investment Decisions

Investment Demand
– Illustrates the relationship between
investment and the real interest rate.
27
Investment Demand
Investment
(trillions of 1992 dollars)
Real interest rate
Expected profit rate
(percent per year)
Low
Average
High
a
4
1.0
1.2
1.4
b
6
0.8
1.0
1.2
c
8
0.6
0.8
1.0
28
Real interest rate (percent per year)
Investment Demand
12
10
c
8
b
6
4
2
0
A rise in the
real interest
rate decreases
investment
a
A fall in the
real interest
rate increases
investment
0.6
0.8
ID
1.0
1.2
1.4
1.6
Investment (trillions of 1992 dollars)
29
Real interest rate (percent per year)
Investment Demand
12
An increase in the
expected profit rate
increases investment
demand
10
8
6
4
2
0
A decrease in the
expected profit rate
decreases investment
demand
0.6
0.8
1.0
ID1
ID2 ID0
1.2 1.4 1.6
Investment (trillions of 1992 dollars)
30
Investment Demand
in the United States
31
Saving Decisions

National Saving
– The sum of private saving and government
saving
S + (T - G)
35
Saving Decisions

The main factors affecting household
saving are:
– The real interest rate
– Disposable income
– Purchasing power of net assets
– Expected future income
36
Saving Decisions

The Real Interest Rate
– The lower the real interest rate, the smaller
is the amount of saving and the greater is
the amount of consumption.

Disposable Income
– The greater a household's disposable
income the greater is its saving.
37
Saving Decisions

Purchasing Power of Net Assets
– Net assets are assets minus debts
– The greater the purchasing power of a
household’s net assets the less is its
saving.
38
Saving Decisions
Expected Future Income
The lower a household’s expected future
income the greater is its saving.
Saving Supply
Illustrates the relationship between saving
and the real interest rate
39
Saving Supply
Real interest
rate
Saving
(percent per year) (trillions of 1992 dollars
a
b
c
4
6
8
0.9
1.0
1.1
40
Saving Supply
12
10
8
SS
A rise in the
real interest
rate increases
saving
c
6
b
4
A fall in the
real interest
rate decreases
saving
a
2
0
0.8
0.9
1.0
1.1
1.2
1.3
Saving (trillions of 1992 dollars)
41
Real interest rate (percent per year)
Saving Supply
SS2
12
10
A decrease
in saving supply
SS0
SS1
8
6
An increase
in saving supply
4
2
0
0.8
0.9
1.0
1.1
1.2
1.3
Saving (trillions of 1992 dollars)
42
Saving Supply in the
United States: 1970–1998
43
Learning Objectives (cont.)

Explain how household saving
decisions are made

Explain how investment and saving
interact to determine the real interest
rate
45
Equilibrium in the
World Economy

Real interest rates are not the same in
every country because some countries
are riskier than others.
46
Equilibrium in the
World Economy


If two countries with equal risk had
different interest rates, people would
want to borrow in the country with a low
interest rate and lend in the country with
a high interest rate.
Interest rates would quickly become
equal in the two countries.
47
Equilibrium in the
World Capital Market
Investment
Saving
Real interest rate
(percent per year)
a
b
c
4
6
8
(trillions of 1992 dollars)
8
6
4
5
6
7
48
Real interest rate (percent per year)
Equilibrium in the
World Capital Market
12
10
SS
Surplus of saving-real interest rate
falls
8
Equilibrium
6
4
ID
2
0
Shortage of saving-real interest rate
rises
4
6
8
10
World saving and world investment (trillions of 1992 dollars)
49
Explaining Changes
in the Real Interest Rate
50
The Role of Government



Part of the capital stock arises from
government investment.
Investment is financed by total saving,
which is made up of private saving plus
government saving.
Therefore, government actions
influence investment, saving, and the
real interest rate.
54
The Role of Government



Most governments are small, but
governments in aggregate are large.
World aggregate government net saving
is close to 20 percent of total saving.
The direction of that saving is negative.
55
The Role of Government

Government Budgets
GDP = C + I + G
GDP = C + S + T

Therefore,
I=S+T–G
For the world, X = M
56
The Role of Government


If net taxes, T, exceed government
purchases, G, the government has a
budget surplus and government saving
is positive.
If government purchases exceed net
taxes, the government has a budget
deficit and government saving is
negative.
57
The Role of Government

Direct Effect of Government Saving
– Dissaving occurs if government saving is
negative.
– The crowding-out effect is the tendency for
a government budget deficit to decrease
investment.
• Raising the real interest rates crowds out
private investment and slows the rate of
economic growth
58
Real interest rate (percent per year)
A Crowding-Out Effect
Government deficit:
dissaving
8
SS
7
PS
6.0
Government deficit raises
interest rate, decreases
investment, and increases
private saving
5.0
3.0
0
ID
9
10
11
World saving and world investment (trillions of 1992 dollars)
59
The Role of Government

Indirect Effect of Government Saving
– Government saving has an indirect effect
on the world capital market because it
influences private saving.
• A change in government saving changes
private saving supply and shifts the PSS curve.
61
The Role of Government

The Barro-Ricardo Effect
– The suggestion is that a government deficit
has no effect on the real interest rate or
investment.
• Deficit spending requires a government to sell
bonds to pay for those expenditures not paid
for by taxes
• It must collect more taxes in the future to pay
the interest on the larger quantity of bonds that
are outstanding
• Taxpayers can see that their taxes will be
higher in the future
62
The Role of Government

The Barro-Ricardo Effect
– The suggestion is that a government deficit
has no effect on the real interest rate or
investment.
• With a smaller expected future income, saving
increases
• They increase saving by the same amount that
the government is dissaving through its deficit
63
Real interest rate (percent per year)
A Barro-Ricardo Effect
12
10
Private saving
increases by the
amount of the
government
deficit
PSS0
PSS1
8
Government
deficit:
dissaving
6
4
ID
2
0
4
6
8
10
World saving and world investment (trillions of 1992 dollars)
64
Government Surplus (Deficit)
65
Saving and Investment in
the National Economy


Saving supply and investment demand
in the world economy determine the
world real interest rate.
Saving does not necessarily equal
investment in a national economy.
68
Saving and Investment in
the National Economy


National investment is financed by
national saving plus borrowing from the
rest of the world.
For the world as a whole, international
borrowing equals international lending.
69
Saving and Investment in
the National Economy


Each nation contributes to world saving
and investment and so influences the
world real interest rate.
A nation’s saving and investment
decisions, along with the world real
interest rate, determine the amount the
nation borrows from or lends to the rest
of the world.
70
Real interest rate (percent per year)
Saving, Investment, and
International Borrowing
12
SS
10
8
World
real interest
rate
International
borrowing
6
4
ID
2
0
0.5
1.0
1.5
2.0
Investment and saving (trillions of 1992 dollars)
71
Rate of Return, ROR
ROR = annual net earnings/capital value
 The rate of return, in problem 1:
 ROR = 1/10 = 10%.
 Compare the ROR to the real interest
rate to decide if the investment is
worthwhile.
74