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Saving, Capital Formation, and Financial Markets Chapter 19 McGraw-Hill/Irwin Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved. Learning Objectives 1. Explain the relationship between savings and wealth 2. Identify and apply the components of national saving 3. Discuss the reasons why people save 4. Discuss the reasons why firms choose to invest in capital rather than financial assets 5. Analyze financial markets using the tools of supply and demand 19-2 Savings and Wealth • Saving is current income minus spending on current needs – The saving rate is saving divided by income • Wealth is the value of assets minus liabilities – Assets are anything of value that one owns – Liabilities are the debts one owes – The balance sheet is a list of an economic unit’s assets and liabilities • Specific date • Economic unit (business, household, etc.) 19-3 Individual Balance Sheet, 1/1/14 Assets Cash Checking account Shares of stock Car (market value) Furniture (market value) Total $80 1,200 1,000 3,500 500 Liabilities Student loan Credit card balance $6,280 $3,000 250 $3,250 Net worth $3,030 19-4 Flow Values and Stock Values • A flow value is defined per unit of time – Income – Saving ■ ■ Spending Wage • A stock value is defined at a point in time – Wealth ■ Debt • The flow of savings 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 19-5 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 19-6 US Stock Prices, 1960 - 2004 19-7 The Bull Market of the 1990s • Stock ownership increased – Direct purchases – Mutual funds – Pension and retirement funds • Stock prices rose rapidly – Capital gains on stocks increased household wealth • May have decreased household savings • Stock market declined, 2000 – 2002 – Household savings remained low – Value of privately-owned homes increased rapidly 19-8 National Savings • Macroeconomics studies total savings in the economy – Household savings is one component – Business and government savings 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 G = government purchases of goods and services NX = net exports 19-9 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 19-10 National Savings, 1960 - 2011 N a tio n a l S a v in g R a tio (% ) • Since 1960, US national savings rate has been 11– 21% whereas Singapore has much higher rate – Less volatile than household savings 60 50 Singapore 40 30 20 United States 10 0 -10 Year 19-11 Private Saving • Private saving is household plus business saving • Household's total income is Y • Households pay taxes (T) from this income – Government transfer payments increase household income • 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 19-12 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 savings makes up the majority of private saving in the US • Business savings is revenues less operating costs less dividends to shareholders • Business savings can purchase new capital equipment 19-13 Public Saving and National Saving • Public saving is the amount of the public sector's income that is not spend 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 19-14 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 dissavings 19-15 Government Saving Federal Government (billions of dollars) Receipts Expenditures State and Local Governments Receipts Expenditures 2000 $2,057.1 1,871.9 1,322.6 1,281.3 Federal Government (billions of dollars) 2010 Receipts Expenditures State and Local Governments Receipts Expenditures $2,385.2 3,718.7 2,128.1 2,095.2 19-16 From Surplus to Deficit • Three reasons for change in U.S. government budget – Government receipts decreased during the recessions of 2001 and 2007-2009 • Lower income during recession means lower taxes – Tax reductions during the first Bush term – Government spending increased • Wars in Iraq and Afghanistan • Homeland Security 19-17 U.S. National Saving, 1960-2010 19-18 Low Household Savings • National savings determines a country's ability to invest in new capital goods – Household savings has been low – Business saving has been significant – In the 1990s, government saving increased • From 1960 to 2002, U.S. national saving rate was fairly stable • Since 2002, U.S. government dissaving has contributed to a decline in the U.S. national saving rate 19-19 Three Reasons for Household Saving 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 19-20 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 savings matters; precautionary savings is low 19-21 Saving and the Real Interest Rate • Savings often take the form of financial assets that pay a return – Interest-bearing checking ■ Bonds – Savings ■ CDs – Mutual funds ■ 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 19-22 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 unearned income 5% 20% Rage Thrift's income grows Start Date 1980 1980 faster End Date 2015 2015 – From 1995 on, Thrifts Real Income $40,000 $40,000 consume more than Real Interest 8% 8% Spends 19-23 Thrifts and Spends • By 2015 – Spend’s consumption is $12,000 more than Thrift's – Retirement savings is $385,000 • Spend's accumulated savings is $77,000 19-24 Savings in Perspective • 8% is lower than the return to mutual funds since 1980 • 20% 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 19-25 Maximize Lifetime Well Being • Psychologists suggest individual self-control may be too weak to produce rational outcomes – Smoking, obesity, gambling, and spending • Devices to support savings – Make savings automatic and withdrawals costly • Penalties for early withdrawal of IRA funds • Easy borrowing supports high levels of current spending – Credit cards – Home equity loans 19-26 Explaining U.S. 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 19-27 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 19-28 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 19-29 Larry and the Lawn Mower • Business plan analysis Net revenue $6,000 Less taxes (20%) $1,200 Less opportunity cost $4,400 Equals VMP of lawnmower $400 Less interest (6%) $240 Equals net benefit $160 • Larry should start the business 19-30 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 19-31 Investment in Computers • Purchases of new computers and software is more than 2.5% of GDP – 24% of all private nonresidential investment • 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 19-32 Investment in Computers, 1960-2010 • Computer technology may have driven increases in productivity since 1995 19-33 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 19-34 Financial Market • If r is above equilibrium, there is a surplus of savings • If r is below equilibrium, there is a shortage of savings Saving S Real interest rate (%) • Equilibrium interest rate equates the amount of saving with the investment funds demanded r Investment I S, I Saving and investment 19-35 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 19-36 Technological Improvement • New technology raises marginal productivity of capital Real interest rate (%) S F r' r E I' I Saving and Investment – Increases the demand for investment funds – Movement up the savings supply curve – Higher interest rate – Higher level of savings and investment 19-37 Government Budget Deficit Increases Real interest rate (%) S' • Government budget deficit increases S F r' E r I Saving and investment • Reduces national saving • Movement up the investment curve • Higher interest rate • Lower level of savings and investment • Private investment is crowded out 19-38 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 • 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 19-39 Saving, Capital Formation, and Financial Markets Financial Markets Investment and Capital National Saving Private Saving Public Saving Wealth Capital Gains and Losses Low Household Saving Interest Rate Government Budget 19-40