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Unformatted text preview: Savings and Capital Formation Reasons to Save For Households brings security, increases wealth For Nations: to Finance Investment by Firms Why Do People Save? Life-Cycle Saving Saving to meet long-term objectives, such as retirement, college attendance, or the purchase of a home Precautionary Saving Saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency Bequest Saving Saving done for the purpose of leaving an inheritance Savings and Wealth Saving Current income minus spending on current needs
Saving Rate Saving divided by income Wealth The value of assets minus liabilities Assets Anything of value that one owns Liabilities The debts one owes Balance Sheet
Cash Checking account Shares of stock Car (market value) Furniture (market value) $ 80 1,200 1,000 3,500 500 $6,280 ______ $3,250 Liabilities
Student loan Credit card balance $3,000 250 Total Net worth $3,030 Earnings ($300/wk) - Expenditures ($280/wk) = Saving ($20/wk) Saving Rate = $20/$300 = 6.7% Wealth ($3,030) = Assets ($6,280) - Liabilities ($3,250) Every dollar a person saves adds to their wealth. Change in Wealth Saving + Capital gains - Capital loss Capital Gains Increases in the value of existing assets Capital Losses Decreases in the value of existing assets Household Saving Rate in the United States, 1960 - 2001 Why do U.S. households save so little? Life-cycle motive Social security and Medicare Low down payment requirements for home mortgages Precautionary motive Stable economic performance Self-control effect U.S. financial markets may have made it "too" easy to borrow Observation: Although household saving has fallen dramatically, national savings has not declined in recent years National Saving and its Components The Measurement of National Saving Saving = Y - spending on current needs Real income or expenditures (Y) = Consumption (C) + Investment (I) + Government (G) + Net exports (NX) National Saving and Its Components
The Measurement of National Saving Assume that all C and G are current need expenditures (that is take away consumption of durable goods that may be used for future needs) Assume NX = 0; therefore The Measurement of National Saving National Saving (S) = Y - C - G U.S. National Saving Rate, 1960 - 2001 National Saving and Its Components Private and Public Components of National Saving National Saving (S) = Y - C - G T = net taxes Private saving = S private = Y - T - C Public saving = Spublic = T G National Saving and Its Components Private and Public Components of National Saving S = S private + Spublic S = (Y - T - C ) + (T - G ) National Saving (S) is composed of saving by households, businesses, and government (federal, state, and local) National Saving and Its Components Government Budget Deficit The excess of government spending over tax collections (G - T) Government Budget Surplus The excess of government tax collections over government spending (T - G) The government budget surplus equals public saving The Three Components of National Saving, 1960- 2001 National Saving and Its Components Is Low Household Saving a Problem? Observations: Macroeconomic Perspective National saving, not household saving, determines the capacity of the economy to invest in new capital goods. National saving has been reasonably stable despite the decline in household saving. National saving, while relatively low, has been sufficient to allow the U.S. to become one of the world's most productive economies. Investment and Capital Formation Investment Investment -- the creation of new capital goods and housing -- is necessary to increase average labor productivity. National saving is the source of funding for investment. Saving, Investment, and Financial Markets
Supply of Savings (S) The quantity supplied of saving is directly related to the real interest rate (r) Demand for Saving (I) The quantity demanded for saving is inversely related to r. Saving and the Real Interest Rate The higher the real rate the greater the reward from saving (the higher the "price" paid to those who hold money). Real Interest Rate (r ) = nominal interest rate (i ) - inflation ( ) Saving, Investment, and Financial Markets Market for Savings The market for S and I (money) will determine the equilibrium (r). If r is above equilibrium, a surplus of savings will exist. If r is below equilibrium, a shortage of savings will exist. The Supply and Demand For Savings
Saving S Real interest rate (%) r Investment I S, I Saving and investment Financial Markets and International Capital Flows Introduction The role of financial markets is to ensure national saving is allocated to the most productive uses The U.S. financial system:
financial institutions and financial Includes markets.
The Banking System Banks are a financial intermediary between savers and borrowers.
Banks specialize in evaluating the quality of a borrower and perform the task at a lower cost. Banks pool savings, which increases the efficiency of making large loans. The Financial System and the Allocation of Saving to Productive Uses Bond
A legal promise to repay a debt, usually including both the principal amount and regular interest payments
and governments sell bonds to raise funds. Corporations Principal Amount : The amount originally lent Coupon Rate: The interest rate promised when a bond is issued The longer the term of the bond the higher the coupon rate. The greater the risk of default, the higher the coupon rate. The Financial System and the Allocation of Saving to Productive Uses Stock (or equity)
A claim to partial ownership of a firm Two sources of return to stockholders Dividend A regular payment received by stockholders for each share that they own Capital gain The difference between the purchase price and selling price, when the selling price is higher International Capital Flows Macroeconomic Roles for International Capital Flows A country with greater investment opportunities than savings can fill the savings gap by borrowing from abroad.
Capital Inflows Purchases of domestic assets by foreign households and firms Capital Outflows Purchases of foreign assets by domestic households and firms International Capital Flows Net Capital Flows Difference between purchases of domestic assets by foreigners and the purchase of foreign assets by domestic residents Basic factors that determine attractiveness of any asset are return and risk Net Capital Inflows and The Real Interest Rate (Return)
Net capital inflows, KI
Domestic real interest rate r KI < 0 Net capital outflows KI > 0 Net capital inflows 0 Net capital inflow KI An Increase In Risk Reduces Net Capital Inflows
KI' KI Domestic real interest rate r Increases in risk reduces the willingness of foreign and domestic savers to hold domestic assets. 0 Net capital inflow KI Saving, Investment, and Capital Inflows
The pool of saving available for domestic investment includes national savings and the funds from savers abroad (KI). S + KI = I The Saving-Investment Diagram For An Open Economy
S S + KI Real interest rate (%) E r* I = demand for capital investment funds S + KI = total supply of saving S = domestic supply of saving r* = equilibrium real interest rate I Saving and investment The Saving-Investment Diagram For An Open Economy
S S + KI Real interest rate (%) E r* Observations For high r, KI are positive and S + KI is to the right of S For low r, KI are negative and S + KI is to the left of S At low r, net saving is reduced in an open economy I Saving and investment International Capital Flows Capital Flows and the Balance of Trade International capital flows allow countries to run trade imbalances. NX = trade balance (net exports) KI = net capital inflows NX + KI = 0 or NX = - KI International Capital Flows National Savings and the Trade Deficit
Y Y = C + I + G + NX
C + I + G from both sides Subtracting - C - I - G = NX S = Y - C - G S - I = NX Assuming I is constant If S increases, NX increases, and vice versa. Since the '70's. S (National Savings) has fallen below I, which implies a negative NX ...
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This note was uploaded on 04/07/2008 for the course ECON 2010 taught by Professor Devkota during the Spring '08 term at Rensselaer Polytechnic Institute.
- Spring '08