ClassicalModelB - The Classical Model: Part B Saving and...

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Unformatted text preview: The Classical Model: Part B Saving and Capital Formation I . Overview We will look at household decisions on saving, aggregate saving and how that feeds into investment and capital formation. We will link consumption, saving, investment and interest rates Her approach is very different from Parkins Loanable Funds My approach is very different from Parkins Loanable Funds I I . Saving & I nvestment Consider Robinson Crusoe. Suppose the only good is corn. He harvest 20 bushels of corn, so in this economy Y = 20 bushels Consumes 18 bushels C=18 Saving Rate= S/ Y=0.1 or 10% Y = current production = current income Why save corn? To increase future consumption Suppose he consumes 18 bushels C = 18 Saving = S = Y C = 2 Saving rate = S/ Y = 0.1, or 10%. Note that Y is current production = current income. Why would he save the corn?- For future consumption- To grow corn next year. I nvestment So S = Y C = I More Complicated Economy A. Definitions: Saving = current income spending on current needs Saving rate = saving/ current income Household Y=$1,000 C=$900 on food, rent , etc. S= Y-C= $100 saving rate =%10 Think of a household Y = $1,000 per month C = $900 on rent, food, transportation S = Y C = $100 So saving rate = 10% B. Wealth Definition: Net Worth = Assets - liabilities We can describe net worth using a balance sheet Assets Liabilities Cash $1,000 Mortgage $400,000 Stocks $5,000 Credit Card $10,000 House $500,000 Car $ 6,000 Total assets $512,000 Total liabilities$410,000 Net worth = Assets minus liabilities=$102k So net worth is $102,000 C. Relationship between Saving and Wealth Saving is a flow Wealth is a stock I ncome and expenditures are flows Bathtub analogy not important Bathtub analogy: Flow: water flowing in - gallons per minute Water level measure at a point in time. I ncome and expenditures are flows Level of banks account are stocks. Let Wealth (t) = level of wealth at end of period t C. Relationship between Saving and Wealth - continued Wealth (t) = wealth (t-1) + income(t) consumption (t) + rate of return (t) X wealth (t-1) Then, Wealth(t) = Wealth(t-1) + I ncome(t) Consumption(t) + Return(t) * Wealth(t-1) Return(t) = return on wealth, includes interest rates and capital gains & losses as a percent of initial wealth. So, Change in Wealth from t-1 to t = Saving(t) + Capital Gains (t)- Capital Losses (t) Example: 1990s Stock prices skyrocketed during the 1990s, which led to capital gains, which increased wealth. Some say this is why the saving rate decreased in the 1990s. But stock prices decreased in early 2000 and saving rate didnt increase Why did saving decrease? Loose money on stocks gained a lot on the house....
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This note was uploaded on 04/07/2008 for the course GENERAL ED MMW 1,2; E taught by Professor Vandehey during the Spring '08 term at UCSD.

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ClassicalModelB - The Classical Model: Part B Saving and...

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