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Chapter 8
Saving, Capital Formation, and
Financial Markets
McGraw-Hill/Irwin
©2009 The McGraw-Hill Companies, All Rights Reserved
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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US Household Saving Rate, 1960 - 2006
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Declining US Saving Rate
 Household savings declined since mid 1980s
 0.4% of household income in 2006
 US rates low compared to other countries
 Low household savings rates may have long-run
consequences, but
 Low household saving can be offset by savings in
businesses or government
 National savings has not declined significantly
 Savings picture is less dire than household savings
suggests
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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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Individual Balance Sheet, 1/1/08
Assets
Cash
Liabilities
$80
Checking account
1,200
Shares of stock
1,000
Car (market value)
3,500
Furniture (market
value)
Total
Student loan
Credit card balance
250
500
$6,280
$3,250
Net worth
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$3,000
$3,030
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Flow Variables and Stock Variables
 A flow variables is defined per unit of time
 Income ■
Spending
 Saving ■
Wage
 A stock variable is defined at a point in time
 Wealth ■
Debt
 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 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
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US Stock Prices, 1960 - 2004
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National Saving
 Macroeconomics studies total saving in the economy
 Household saving is one component
 Business and government saving are other parts
 Start with the definition of production and income for
the economy
Y = C + I + G + NX
Y = aggregate income
C = consumption
expenditure
I = investment spending
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G = government
purchases of goods
and services
NX = 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, 1960 - 2006
 Since 1960, national saving rate has been 11 – 18%
 Less volatile than household savings
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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
 Interest is paid to government bond holders
Use T to denote net taxes:
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
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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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From Surplus to Deficit
 Three reasons for change in government budget
 Government receipts decreased during the 2001
recession
 Lower income during recession means lower taxes
 Tax reductions during the first Bush term
 Government spending increased
 Wars in Iraq and Afghanistan
 Homeland Security
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National Saving, 1960 - 2006
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Three Reasons for Household Saving
1. Life-cycle saving is to meet long-term objectives
■ Purchase a home
 Retirement
 Children's college attendance
2. Precautionary saving is for protection against
setbacks
■ Medical emergency
 Loss of job
3. Bequest saving is to leave an inheritance
 Mainly higher income groups
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Saving and the Real Interest Rate
 Savings often take the form of financial assets that pay
a return
■ Bonds
 Interest-bearing checking
■ CDs
 Savings
■ Stocks
 Mutual funds
 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
 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
Start Date
1980
1980
 Thrifts’ 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
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Thrifts and Spends
 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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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
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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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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
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Larry 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
 Larry 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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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
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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
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 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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