Download Chapter 8

1
C h a p t e r
08
CAPITAL,
INVESTMENT,
AND SAVING
Outline
Illusion or Real?
A. In 1999, a stock market boom increased wealth by four
times the amount of saving measured by the national
income accounts. Which is the true measure of saving?
B. Saving finances investment in new capital, which
increases labor productivity. How do firms make
investment decisions and households make saving
decisions, and how do capital markets coordinate the two?
I.
Capital and Interest
A. Investment and Capital
1. The capital stock is the total amount of plant,
equipment, buildings, and inventories, physical
capital.
2. Gross investment is the purchase of new capital.
Depreciation is the wearing out of the capital stock. Net
investment equals gross investment minus depreciation,
and net investment is the addition to the capital
stock.
3. Figure 23.1 (page 526/180) shows investment and the
capital stock for the period 1981–2001.
4. The amount of gross and net investment decreases
during recessions and increases during expansions.
5. The capital stock has increased every year since 1981
by an amount that fluctuated between $0.3 trillion and
$0.7 trillion per year.
B. Saving
1.
Saving is current income minus current expenditure,
and in part finances investment.
2. Saving consists of personal saving, personal disposable
income minus consumption expenditure; business saving,
retained profits and additions to pension funds by
business; and government saving, the government’s budget
surplus. Any of these components can be negative.
3. Figure 23.2 (page 527/181) shows the three components
and the total for 1981–2001.
4. Figure 23.3 (page 527/181) shows investment minus
saving, the saving gap, for the United States over
1981–2001, illustrating how the gap is near zero in
recessions but otherwise positive, and grew during the
1990s.
C. Interest Rates
1. The return on capital is the real interest rate, which
(approximately) equals the nominal interest rate minus
the inflation rate. Figure 23.4 (page 182) shows the
real interest rate from 1981 to 2001, which fluctuates
around an average close to 6 percent a year.
II. Investment Decisions
A. The Expected Profit Rate
1. Investment depends on the expected profit rate and the
real interest rate.
2. The expected profit rate is relatively high during
expansions and relatively low during recessions.
3. Increases in technology can increase the expected
profit rate.
4. Taxes affect the expected profit rate because firms
are concerned about the after-tax profit rate.
B. The Real Interest Rate
The real interest rate is the opportunity cost of
investment.
C. Investment Demand
1. Investment demand is the relationship between the level
of planned investment and the real interest rate.
2. The investment demand curve, illustrated in Figure
23.5 (page 530/184), plots the relationship between
investment demand and the real interest rate.
a) The investment demand curve slopes downward. A rise
in the real interest rate (say from 4 percent to 6
percent) decreases the quantity of planned
investment demanded (from $1.2 trillion at A to
$1.0 trillion at B) along investment demand curve
ID in Figure 23.5(a).
b) If the expected profit rate increases, the
investment demand curve shifts rightward, say, from
ID0 to ID1 in Figure 23.5(b) (page 184).
D. Investment Demand in the United States
1. Figure 23.6 (page 531/185) interprets investment
demand in the United States between 1981 and 2001.
Movements along an investment demand curve show
changes in the quantity of investment that result from
changes in the real interest rate, and shifts of the
investment demand curve show changes in investment
demand that result from changes in the expected profit
rate.
III. Saving Decisions
A. National saving is the sum of private saving and government
saving.
1. Households divide their disposable income between
consumption expenditure and saving.
2. Saving is affected by the real interest rate,
disposable income, wealth, and expected future income.
B. Real Interest Rate
The higher the real interest rate, the greater is a
household’s opportunity cost of consumption and so the
larger is the amount of saving.
C. Disposable Income
The higher the disposable income, the greater is a
household’s saving.
D. Wealth
The greater is a household’s wealth, other things
remaining the same, the greater is its consumption and
the less is its saving.
E. Expected Future Income
The higher a household’s expected future income, the
greater is its current consumption and the lower is its
current saving.
C. Saving Supply
1. Saving supply is the relationship between saving and the
real interest rate, other things remaining the same.
2. Figure 23.7(a) (page 533/187) shows a saving supply
curve, which slopes upward because a rise in the real
interest rate increases saving.
3. Figure 23.7(b) (page 533/187) shows the effect of a
change in any other influence on saving, which changes
saving supply and shifts the saving supply curve.
D. Saving Supply in the United States
1. Figure 23.8 (page 534/188) illustrates saving supply
in the United States from 1981 to 2001.
2. The U.S. saving supply curve has tended to shift
rightward, except in recessions, because of growth in
disposable income.
IV. Equilibrium in the World Economy
A. The real interest rate is determined in the global market
because capital can readily move from one country to
another; that is, one nation’s saving can finance another
country’s investment.
B. Determining the Real Interest Rate
1. The real interest rate is determined by the world
investment demand and world supply of savings.
2. In Figure 23.9 (page 535/189), ID is the world
investment demand curve, SS is the world supply of
saving curve, and the equilibrium real interest rate
is 6 percent. At the equilibrium real interest rate,
there is neither a shortage nor surplus of saving.
C. Explaining Changes in the Real Interest Rate
1. Figure 23.10 (page 536/190) shows how investment
demand and saving supply in the world economy brought
real interest rate fluctuations.
2. The real interest rate increased during the early
1980s, peaked in 1984, fell through 1991, and was
relatively steady during 1991–2001.
3. From 1981 to 1984, an increase in the expected profit
rate helped by a recovery from recession in the United
States increased world investment demand.
4. In 1984 the investment demand curve had shifted
rightward but the saving supply curve had not shifted
and the real interest rate reached a peak of almost 9
percent a year.
5. After 1984 the saving supply curve shifted more
strongly rightward and, as a result, the real interest
rate fell. After 1991, saving supply and investment
demand shifted rightward at similar rates, so the real
interest rate did not fluctuate much.
V. The Role of Government
A. Government saving is part of total saving. Because funds
flow between countries and the real interest rate is
determined in the world market, it is the aggregate
saving of all governments throughout the world that
matters. In total, government is large; worldwide,
government saving is negative (governments have a
deficit) at about 10 percent of total saving.
B. Government Budgets
1. Although each country has imports and exports, when we
sum over all countries to obtain world totals, exports
and imports are zero, so world GDP = C + I + G. Also,
world GDP = C + S + T. From these two equations, you
can see that for the world as a whole I = S + T – G.
2. If net taxes exceed government purchases, T > G, the
government has a budget surplus and government saving
is positive; if net taxes are less than government
purchases, T < G, the government budget is in deficit
and government saving is negative.
C. Direct Effect of Government Saving
1. Government saving is part of total saving. Hence the
direct effect of a government budget deficit reduces
total saving.
2. When total saving decreases, the real interest rate
rises and the equilibrium quantity of investment
decreases.
3. The crowding-out effect occurs when a government budget
deficit raises the real interest rate and decreases
investment. Figure 23.11 (page 538/192) illustrates.
D. Indirect Effect of Government Saving
1. A government budget deficit also has an indirect
effect that offsets the direct effect.
2. The Ricardo-Barro effect suggests that private saving
rises one-to-one with a government budget deficit
because households realize that a government budget
deficit implies higher taxes in the future.
3. The Ricardo-Barro effect concludes that a government
budget deficit has no effect on the real interest rate
and hence does not decrease the quantity of
investment. Figure 23.12 (page 539/193) illustrates.
4. Reality probably lies between total crowding out and a
complete Ricardo-Barro effect; that is, there is
partial crowding out and somewhat higher real interest
rates in response to a worldwide government budget
deficit, but also some increase in private saving in
anticipation of potential higher taxation in the
future.
E. Government Deficits Today
1. Figure 23.13 (page 540/194) shows estimates of total
government surplus and deficit for the advanced
economies over 1983–2001, as a percentage of GDP. This
is roughly equivalent to the worldwide government
balance, because the net balance of developing
countries is small compared to world GDP. Worldwide,
the deficit was close to 5 percent of GDP in the early
1980s and again in 1992, but by 2000 was close to
zero.
VI. Saving and Investment in the National Economy
A. The world real interest rate determines the quantity of a
nation’s saving and investment.
B. International Borrowing and Lending in the World Today
1. If, at the world real interest rate, the quantity of a
nation’s investment exceeds that of its saving, the
country borrows from the rest of the world. Figure
23.14 (page 541/195) illustrates this case. In Figure
23.14, the nation borrows $0.5 trillion from the rest
of the world.
2. When a nation borrows from the rest of the world, its
net export balance is negative; that is, the nation
imports more than it exports.
3. If, at the world real interest rate, the quantity of a
nation’s investment is less than the quantity of its
saving, the nation loans to the rest of the world and
exports more than it imports.
C. Government Deficit and International Borrowing
1. An increase in the government deficit decreases the
nation’s total saving and increases international
borrowing.
2. U.S. net exports have been negative for the past 20
years because national saving has been less than
investment.
a) The government budget deficit in past years has
helped decrease national saving and hence
contributed to international borrowing.
b) Because it is the world real interest rate that
determines investment, a U.S. government budget
deficit has a smaller effect on U.S. interest
rates, and smaller crowding-out effect, than often
popularly believed.