Transcript Frank & Bernanke 4th edition, 2009 Ch. 8: Saving and Capital Formation Introduction  Motives for Saving To meet future expenditures  Protect against an economic emergency 

Frank & Bernanke
4th edition, 2009
Ch. 8: Saving and
Capital Formation
1
Introduction

Motives for Saving
To meet future expenditures
 Protect against an economic emergency
 Produce capital goods

2
What Is Saving?

Saving at the household level is the
amount of current income that is not
currently consumed.
Joan has an income of $1000 this month.
 She buys food for $300, pays rent for
$250, buys clothes, entertainment,
transportation, education for $300,
contributes to a Christmas Club $30, buys
$50 of her company’s stock, and adds $50
to her checking account and pays $20 she
owes to Jim.
 What is her saving?

3
What Is Saving?

Saving at the household level is the
amount of income that is added to
wealth.
Wealth is the net worth of individuals or
households or firms.
 Net worth is defined as the difference
between assets one owns minus liabilities
one owes.
 Why would Joan’s $150 in savings
increase her wealth?

4
Net Worth
For Joan, her net worth is the difference
between her assets and her liabilities.
 Her net worth is a combination of both
real and financial assets.
 Because Joan may experience both
capital gains and capital losses, even if
she has zero savings, her net worth
may change.

5
Savings and Wealth

Capital Gains


Increases in the value of existing assets
Capital Losses

Decreases in the value of existing assets
6
• During the 1990s, household saving fell while wealth rose
• Households acquired stocks in the 1990s and stock prices rose
• 2000 - 2001 the fall in stock prices was offset by rising home values
http://www.inflationdata.com/inflation/images/charts/Stocks/Stock_Market_inflation_chart.htm
7
Saving At the National Level
The portion of income not spent on
consumption but spent on acquiring
wealth by households, firms and
governments will constitute the national
saving.
 If no part of national saving is used to
acquire wealth abroad and no foreigners
acquired assets here, then national
savings will have to equal to capital
formation.

8
What Is Capital Formation?
Net additions to the stock of capital is
capital formation.
 At the household level, additions to net
worth (savings) is “capital formation.”
 At the national level, all the assets
minus liabilities will constitute net worth
and additions to assets or reductions
from liabilities will increase net worth.

9
What Is Capital Formation?




Another name for capital formation is
“investment.”
We basically seem to say that “savings” and
“investments” are the same.
However, we want to emphasize that
investments are additions to capital stock,
buildings, roads, infrastructure, machines,
tools.
Savings are primarily financial (except
homes).
10
Home Example





You buy a home that is built this year.
You have $15,000 saved in bank accounts,
stocks and bonds which you use for down
payment.
You borrow the remaining $85,000 from Bank.
The market value of the home remains at
$100,000.
Assuming that your net worth was $15,000 before
you bought the house, what is it now?
11
Home Example
The Bank had no assets and 85 people
deposited $1000 each - liabilities of $85K
and cash (assets) of $85K.
 The sum of net worth for depositors is $85K.
 The Bank loaned you the money so it has a
piece of paper that says you owe it $85K.
 Its assets and liabilities are equal.
 The savings of the 85 people plus your $15K
bought the new house.

12
Home Example




The financial savings of $100,000 is used to
buy a new home.
The new home is an investment worth
$100,000. It increases the capital stock of the
nation.
You own 15% of the home and the savers
own 85%.
Without the existence of savings, the
investments couldn’t have been financed.
13
Savings and Investment
The importance of saving and
investment is the ability to convert the
financial wealth into capital stock.
 The more the capital of a country, the
higher is the average labor productivity.
 The higher the average labor
productivity, the higher is the standard
of living.

14
Answers to Problem 1, p. 266
1a.
Corey’s balance sheet is as follows:
ASSETS
$300
Bike
200
Cash
400
Baseball card
Checking acct. balance 1200
LIABILITIES
Credit card debt $150
Electric bill due 250
2100
400
TOTAL
Net worth
1700
Corey’s assets have value of $2100, his liabilities are $400, so his net worth is
$2100 - $400, or $1700.
The card is worth zero rather than $400. Assets decline to $1700, liabilities are
b.
unchanged, net worth falls by $400 to $1300. This is an example of a capital loss; no
saving (positive or negative) has occurred.
Liabilities are reduced by $150, assets are unchanged, net worth increases by
c.
$150 to $2250. Note that paying off a debt out of current income is a form of saving.
Assets decline by $150, as the checking account balance falls from $1200 to
d.
$1050. Liabilities also decline by $150, as the credit card debt falls to zero. Net worth
(assets minus liabilities) is unchanged. No saving has been done in this case, rather an
existing asset was set off against an existing liability.
15
Answers to Problem 2, p. 267
2a.
b.
c.
d.
e.
f.
Flow. GDP represents production per unit of time, such as a year or a quarter.
Flow. National saving is measured per unit of time, analogous to individual
saving.
Stock. This value is measured at a point in time.
Stock. Again, the value is measured at a point in time.
Flow. The deficit is the government’s spending less its receipts. Spending and
receipts are measured per unit of time, such as a year or quarter.
Stock. The quantity of government debt outstanding is measured at a point in
time.
16
Real Interest Rates
Real interest rates will play a pivotal role
in affecting the decisions of 85 savers,
your readiness to borrow the $85,000
and the bank’s willingness to lend the
money.
 There are many reasons why people
save and why people invest; but real
interest rates appear as one of these
reasons in both cases.

17
Why Do People Save?

Life-Cycle Saving

Saving to meet long-term objectives, such as
retirement, college attendance, or the
purchase of a home
18
Why Do People Save?

Precautionary Saving

Saving for protection against unexpected
setbacks, such as the loss of a job or a
medical emergency
19
Why Do People Save?

Bequest Saving

Saving done for the purpose of leaving an
inheritance
20
Why Do People Save?

Observation

If people are target savers, a high real interest
rate may reduce saving.
21
Why Do People Save?




Payroll deductions for Christmas Clubs,
retirement pension funds might increase
savings by eliminating the temptation to spend
the available income.
Easy terms to borrow (high limits on credit
cards, home equity loans) might increase the
spending and reduce savings.
Higher real interest rates might convince people
to save more.
Capital gains might reduce savings; capital
losses might increase savings.
22
Self-Control Hypothesis

George Lowenstein, Brian Knutson, Drazen
Prelec (Neuron, 2007)


People lack the self-control to save
Techniques to offset the lack of self-control and
increase savings



Payroll savings
Retirement accounts with limited withdrawals
Factors that may reduce self-control and savings


Home equity loans
Credit cards with high borrowing limits
23
Why Do People Save?

Demonstration effects
 People
use spending by others to measure the
adequacy of their own spending.
 When satisfaction depends on relative living
standards, an upward spiral of spending can
occur, which reduces savings.
24
Why Do People Save?
1. What does the phrase "keeping up with the Jones'" imply for saving rates?
2. Why might people who lived through the Great Depression have a different propensity to
save than people who only remember the recent economic expansion?
3. What effect is the retirement of "baby boomers" likely has on saving in the United States?
1. Demonstration effect will lower the saving rate.
2. They would have more need for precautionary saving. Also, they might be more frugal,
hoping to save more for retirement because they don’t have the confidence of social
security. They might also want to bequeath more to their children because they don’t
trust the future. (Precautionary Saving; Life-cycle Saving; Bequest Saving)
3. As more people retire compared to people in the work force, additions to savings will be
less than withdrawals from savings resulting in a decrease in savings.
25
Why do Japanese households
save so much?

Life-cycle motive




Bequest motive


Long life expectancy
Retire relatively early
Housing prices are very high and down payment
requirements are also high
Parents, who live with their children after retirement,
leave a large inheritance
Precautionary motive

Very high job security reduces the precautionary
motive
26
Why do U.S. households
save so little?

Life-cycle motive



Precautionary motive



Stable economic performance
Strong capital gains
Self-control effect


Social security and Medicare
Low down payment requirements for home
mortgages
U.S. financial markets may have made it “too” easy to
borrow
Demonstration effect

Increased real wage inequality
27
Household Saving Rate in the U. S.
Observations
•Household saving has fallen dramatically until the late recession
•National saving has not declined until recently
28
http://www.bea.gov/briefrm/saving.htm
29
http://www.economist.
com/finance/displaysto
ry.cfm?story_id=13240
636
30
U.S. National Saving
Rate, 1960 - 2001
31
National Saving
Y = C + I + G + NX
 Assume for now that NX=0.
 Y or GDP is also the incomes earned by
households (remember the circular
flow?)
Y=C+T+S
C+T+S=C+I+G

32
National Saving
(T - G) + S = I
 Government Saving + Private Saving =
Investment
 Investments (increasing the capital
stock) is financed by national saving.
 National Saving, therefore is the sum of
Public Saving and Private Saving.
 (T - G) + S = I = Y - C - G

33
Gross Saving
Organize the
table in terms
of S = I.
http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=137&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&
FromView=YES&Freq=Qtr&FirstYear=2007&LastYear=2009&3Place=N&Update=Update&JavaBox=no#Mid
34
Saving and
Investment by
Sector
[Billions of dollars]
http://www.bea.gov/iTable/iTable.cfm?R
eqID=9&step=1#reqid=9&step=3&isuri=
1&910=X&911=0&903=137&904=2008
&905=2011&906=A
35
Real Gross and Net
Domestic Investment by
Major Type, Chained
Dollars
[Billions of chained (2005)
dollars]
http://www.bea.gov/iTable/iTable.cfm?ReqID=9
&step=1#reqid=9&step=3&isuri=1&910=X&911
=0&903=140&904=2008&905=2011&906=Q
36
Savings Rates
Years
Gross
Saving
Personal
Saving
Government
Saving
Business
Saving
1991
16.9%
6.18%
-1.38%
12.10%
1992
15.9%
6.53%
-2.48%
11.85%
1993
15.6%
5.27%
-1.80%
12.14%
1994
16.3%
4.45%
-0.61%
12.46%
1995
16.9%
4.06%
-0.11%
12.95%
1996
17.2%
3.47%
0.75%
12.98%
1997
18.0%
3.03%
1.90%
13.07%
1998
18.8%
3.44%
3.11%
12.25%
1999
18.4%
1.73%
3.87%
12.79%
2000
18.1%
0.69%
4.69%
12.72%
2001
16.5%
2.00%
1.45%
13.05%
2002
14.1%
3.22%
-0.65%
11.53%
2003
13.5%
2.76%
-1.36%
12.10%
37
Savings Rates
% of GNP
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%1990
1992
1994
1996
1998
2000
Gross Saving
Personal Saving
Government Saving
Business Saving
2002
38
Low Household Savings




By international standards, personal savings
in the US are low and getting even lower.
Since it is national savings that matter for
investments, high business saving and
increasing government saving eliminate the
low personal saving.
Increase in wealth might be the reason for
decreasing household saving.
Low savings and negative wealth for the poor
households is a major concern.
39
Investment and Capital
Formation
The importance of national saving is that it
finances investment.
 Investment is capital formation.
 Capital formation increases the physical
capital in a country, raising average labor
productivity.

40
Factors That Affect Investment





Price of capital goods: lower price, more
investment.
Real interest rate: lower real interest rate,
more investment.
Technological advancement that increases
the marginal product of capital.
Lower taxes on the revenues generated by
capital.
A higher relative price for the firm’s output.
41
Investment in Computers
and Software, 1960 - 2001
42
Problem 7, p. 257
Ellie and Vince are trying to decide whether to purchase a new home. The house they want
is priced at $200,000. Annual expenses such as maintenance, taxes, and insurance equal 4%
of the home’s value. If properly maintained, the house’s real value is not expected to change.
The real interest rate is 6%. They pay no down-payment and ignore mortgage tax-deduction.
(a) If they are willing to pay $1500 monthly rent for a similar house, should they buy the house?
(b) What if they were willing to pay $2000?
(c) What if the real interest rate were 4%?
(d) What if the price of the house were $150,000?
(e) Why do home-building companies dislike high interest rates?
(a)
(b)
(c)
(d)
No.
Yes.
Yes.
Yes.
43
Savings and Investments





People save to
accumulate wealth.
People save for lifecycle reasons.
People save for
precautionary reasons.
People save for
bequeathing.
People save in
response to high real
interest rates.





People invest when the
price of capital goods
fall.
When the marginal
product of capital
increases due to
technology.
When the relative price
of the output rises.
When taxes on revenue
generated are lowered.
When real interest rates
are low.
44
Financial Markets
Real interest rate
S
I
Savings are funds to
be lent. Savers are
also lenders. Investors
are borrowers. Ceteris
paribus, they both
respond to real interest
rates.
What happens when r
is not at equilibrium?
Saving and investment
45
The Effect of a New Technology
on National Saving and Investment
Real interest rate (%)
S
F
r’
r
New Technology
• Raises the marginal
productivity of capital
• This increases the
demand for capital
E
I’
I
Saving and investment
46
Increase in the Government Budget Deficit
Real interest rate (%)
S’
S
Increases in the government
budget deficit:
•Reduces S public and
national saving
•r will increase
•S & I will fall
F
r’
E
r
I
Saving and investment
47
Shifts







What happens when stock market falls?
What happens when war breaks out?
What happens when a new child is born to the family?
What happens when the government budget moves from
surplus to deficit?
What happens when new legislation is passed that
increases Social Security payments in the future?
What happens when “baby boom” generation reaches
working age?
What happens when “baby boom” generation reaches
retirement?
48
Shifts
What happens when price of computing
power drops by 50%?
 What happens a new software
increases the output of a computer?
 What happens when the designs
created by using a computer/software
are much in demand – higher in price?
 What happens when the government
puts an extra tax on mobile phones?

49