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Chapter 2
Measuring
macroeconomic
performance:
Saving and wealth
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Learning objectives
1. What is the relation between saving and wealth?
2. For what reasons do people save?
3. What had happened to the household saving ratio in
Australia?
4. What does national saving mean?
5. How are investment and capital formation related?
6. What role does the real interest rate play in
determining saving and investment?
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2-2
Chapter organisation
2.1
Saving and wealth
2.2
Why do people save?
2.3
National saving and its components
2.4
Is low household saving a problem?
2.5
Investment and capital formation
2.6
Saving, investment and financial markets
Summary
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2-3
Balance sheet identities
• Assets are anything of value that one owns.
• Liabilities are the debts one owes.
• Net worth is equal to assets minus liabilities.
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Balance sheet identities (cont.)
• Saving is current income minus current spending.
• Saving rate is the proportion of total income devoted
to saving.
• Capital gains (or capital losses) are changes in the
values of the assets owned.
• Change in net worth = Saving + Capital gains –
Capital losses
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Example: Mary’s balance sheet
If Mary saved $20 this week how would that change
her net worth?
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Stocks and flows
• Flow variables are measured over a period of time.
– Example: Mary saves $20 per week.
• Stock variables are measured at a point in time.
– Example: Mary’s wealth of $3030 on 1 January 2011.
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The link between saving and wealth
• The key to a rise in future living standards is
economic growth.
• The key to economic growth is investment in human
and physical capital formation.
• Capital formation requires saving.
• A balance between current consumption and saving
is an important indicator of good macroeconomic
performance.
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Chapter organisation
2.1
Saving and wealth
2.2
Why do people save?
2.3
National saving and its components
2.4
Is low household saving a problem?
2.5
Investment and capital formation
2.6
Saving, investment and financial markets
Summary
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Why do households save?
• Households generally save for three reasons:
1. Life-cycle saving

Examples: Saving for cars, houses, children’s education and
future retirement.
2. Precautionary saving:

Examples: Saving for a ‘rainy day’, such as job loss or costly
health problem.
3. Bequest saving:

Examples: To leave an inheritance for children or others.
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Household saving in Australia
Figure 2.1 Household saving rate in Australia, September 1959 to December 2009
Is a low household saving rate a concern for the
Australian economy?
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2-11
Saving and the real interest rate
• The real interest rate is the ‘reward’ for saving.
– The higher the interest rate, the more attractive saving is, as
the higher the benefit received from saving.
• However, for ‘target’ saving:
– Higher interest rates will achieve the target quicker, and can
actually reduce saving.
• Empirical evidence suggests modest increases in
saving at higher interest rates.
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Saving, self-control and demonstration
effects
• People don’t always do what is in their best interests
to do.
– Self-control is required to save.
• The availability of government support and easy
finance can reduce the motivations to save.
•
The demonstration effect
– Additional spending by some consumers can stimulate
additional spending by others.
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2-13
Chapter organisation
2.1
Saving and wealth
2.2
Why do people save?
2.3
National saving and its components
2.4
Is low household saving a problem?
2.5
Investment and capital formation
2.6
Saving, investment and financial markets
Summary
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2-14
The measurement of national saving
• Recall our national income accounting identity:
GDP = Y = C + I + G + NX
• For simplicity, let NX = 0
Y=C+I+G
• National saving is current income less spending on
current needs.
• What part of this spending is just for current needs?
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Spending on current and future needs
• Investment (I)
– Spending on capital equipment to expand the economy’s
future productive capacity; it is saving.
• Consumption (C)
– Spending largely on current needs, but also durable goods
which provide services into the future.
• Government spending (G)
– A mixture of spending on current needs and funding for
future needs.
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Private and public components of
national saving
• If all of C and G is spending on current needs and
NX = 0, national saving becomes:
S=Y–C–G
• National saving is the total saving done by the private
sector (i.e. households and firms) and by the public
sector (i.e. governments).
• Let T denote net taxes
– T is taxes paid by the private sector to the government minus
income payments made by governments to households.
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Private and public components of
national saving (cont.)
• Adding T to our definition of national saving:
S=Y–C–G+T–T
= (Y – T – C) + (T – G)
• Private saving = Sprivate = Y – T – C
• Public saving = Spublic = T – G
S = Sprivate + Spublic
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Public saving and the government
budget
• Government budget surplus arises when government
spending is less than tax collection.
– It is also called public saving = (T – G) > 0
• Government budget deficit arises when government
spending is more than tax collection.
– It is also called public debt = (T – G) < 0
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Net national saving by sector
Figure 2.8 Australia’s net national savings as a proportion of gross national
income, by sector
What drives the trend of national saving?
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Chapter organisation
2.1
Saving and wealth
2.2
Why do people save?
2.3
National saving and its components
2.4
Is low household saving a problem?
2.5
Investment and capital formation
2.6
Saving, investment and financial markets
Summary
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2-21
Is low household saving a problem?
• Household saving in Australia fell substantially during
the 1990s and has been negative in the early 2000s.
• Is low household saving a serious problem? No.
– Macroeconomists argue that it is total national saving that
matters.
– Low household saving has been offset with increases in
saving by business firms and government budgets going
from deficit to surplus in the 2000s.
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Is low household saving a problem?
(cont.)
• Is low household saving a serious problem? Yes.
– Microeconomists argue that the low household saving rate
does signal a problem of growing inequality.
– Lower income families don’t benefit from the increase in
wealth from business saving.
– These same families are not increasing their wealth through
their own saving either.
Copyright  2011 McGraw-Hill Australia Pty Ltd
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2-23
Chapter organisation
2.1
Saving and wealth
2.2
Why do people save?
2.3
National saving and its components
2.4
Is low household saving a problem?
2.5
Investment and capital formation
2.6
Saving, investment and financial markets
Summary
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2-24
Investment decision
• What factors determine whether and how much firms
choose to invest?
• Investment decision is made based on the costbenefit principle.
– Marginal cost of investment ≥ Marginal benefit of investment
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Example: Should Patrick buy a ride-on
lawnmower?
• Example: Cost of lawnmower $4000
– Borrows: $4000 @ 6%pa
– Revenues: net $6000 after expenses
– Taxation rate: 20%
• Investment decision rule
– Patrick should buy the lawnmower if costs of the business
and the benefit equal the value of the marginal product of
the mower.
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Example: Should Patrick buy a ride-on
lawnmower (cont.)?
• For Patrick:
$6000 net revenue
LESS $1200 tax (@ 20%)
$4800
- If Patrick could earn $4400 after taxes by working at an
alternative job, then the value of the marginal product of
investing in his lawn mowing business is $400 (or $4800 –
$4400).
- If Patrick needs to borrow the $4000 purchase price @ 6%
pa this adds $240 to his costs. He will still benefit with $160
(or $400 – $240) above the next best alternative.
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Example: Should Patrick buy a ride-on
lawnmower (cont.)?
• Patrick should buy the mower if the value of the
marginal product is greater than zero.
• The key factors that determine the marginal
product are:
– Cost of the capital. If the lawn mower costs $7000 instead of
$4000, his interest @ 6% is $420, which exceeds the $400
marginal product.
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Determinants of the level of investment
• Real interest rate
– If the interest rate increases to 12% instead of 6%, his
interest expense is $480 which exceeds the $400 marginal
product.
• Taxation rate
– If taxes increase to 25% on net revenue, his marginal
product of $100 is exceeded by the $240 interest expense.
• Other impacts on revenues
– If the running costs are different than Patrick expected, or
the price he can charge for his service changes, these will
impact on the costs and benefits that determine the value of
the marginal product.
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Determinants of the level of investment
(cont.)
• Even if a firm finances capital from their savings, the
real interest rate is an opportunity cost of alternative
uses of their finance.
– Increased real interest rates increase the opportunity cost.
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Chapter organisation
2.1
Saving and wealth
2.2
Why do people save?
2.3
National saving and its components
2.4
Is low household saving a problem?
2.5
Investment and capital formation
2.6
Saving, investment and financial markets
Summary
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2-31
Saving, investment and financial
markets
• Saving and investment decisions are determined by
different forces.
• In a closed economy without international borrowing
or lending, national saving must equal national
investment.
• This equality of saving and investment occurs
through financial markets, where the demand for
saving (for investment) is made equal to the supply
of saving through the price, which is the real
interest rate.
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Supply and demand for saving
• The demand curve for savings shows how the
demand for investment funds, when all else is equal,
varies with changes in the real interest rate.
• The supply curve for savings shows how the supply
of savings, when all else is equal, varies with
changes in the real interest rate.
• Changes in factors other than the real interest rate
that affect the supply of funds or demand for funds
will shift the curves.
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The market for saving
Figure 2.10 The supply of and demand for savings
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Changes in demand for investment
• Anything that changes the marginal product of the
investment will shift the demand for investment funds.
• This is because:
– anything that decreases the marginal product of the
investment will reduce the demand for investment funds,
at every interest rate level
– anything that increases the marginal product of the
investment will increase the demand for investment funds, at
every interest rate level.
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Example: The effects of new
technology
Figure 2.11 The effects of a new technology on national saving and investment
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Changes in supply of savings
• Anything that changes the level of saving in the
economy will shift the supply of savings.
• This is because as saving is made up of public and
private saving, anything that makes households or
businesses or governments choose to change their
saving rate will shift the supply curve.
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Example: the effects of government
budget deficits
Figure 2.12 The effects of an increase in the government budget deficit on
national saving and investment
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Chapter organisation
2.1
Saving and wealth
2.2
Why do people save?
2.3
National saving and its components
2.4
Is low household saving a problem?
2.5
Investment and capital formation
2.6
Saving, investment and financial markets
Summary
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2-39
Summary
• It is the level of national saving, not household saving, that
matters for a country’s economic growth in the long run.
• A higher level of national saving transpires into a higher
level of national investment.
• In a closed economy, national saving must equal national
investment.
• The real interest rate is a key determinant in saving and
investment decisions.
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Summary (cont.)
• The demand curve for savings is downward-sloping,
meaning people are more willing to borrow money at lower
real interest rates.
• The supply curve for savings is upward-sloping, meaning
people are more willing to save money at higher real
interest rates.
• The financial market is in equilibrium when the demand
curve for savings is equal to the supply curve for savings.
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