Saving, Capital Formation and Financial Markets
Xi Wang UMSL, Summer MB MC
Learning Objectives Slide 2
1. Explain the relationship between savings and wealth Chapter Chapter Saving 9: and Capital Formation 2. Recognize and work with the components of national saving 3. Understand the reasons people save 4. Discuss the reasons firms choose to invest in capital 5. Analyze financial markets using the tools of supply and demand
Copyright c 2004 by The McGraw-Hill Economic Growth Slide 2 Companies, Inc. All rights reserved. MB MC Why do Individuals and Nations Slide Save, And Why do we care? 3
Individuals save Chapter Saving 9: and Capital Formation
To meet future expenditures (life cycle motive)
To protect against an economic emergency (precautionary motive) Nations save
To produce new capital goods – to promote growth and higher standards of living in the future
National Saving equals savings by households, businesses and governments
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Savings and Wealth Slide 4
Saving of an economic unit equals current Chapter Saving 9: and Capital Formation income minus spending on current needs Saving Rate of any economic unit is its Saving divided by its income Wealth: The value of assets minus liabilities Assets: Anything of value that one owns either financial (cash, stocks, bonds, etc.) or real (real estate, jewelry, consumer durables like cars, etc.) Liabilities: The debts one owes (credit card balances, loans, mortgages, etc.)
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Savings and Wealth Slide 5
By comparing an economic unit’s assets and Chapter Saving 9: and Capital Formation liabilities economists calculate that unit’s wealth – also called Net Worth. This comparison is done using a list of assets and liabilities as on a particular date – called the unit’s Balance Sheet.
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Mr. A’s Balance Sheet Slide
6 Chapter Chapter Saving 9: and Capital Formation
Assets Liabilities Cash $ 80 Student loan $3,000 Checking account 1,200 Credit card balance 250 Shares of stock 1,000 Car (market value) 3,500 Furniture (market value) 500 ______Total $6,280 $3,250 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)
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Savings and Wealth: Flows and Slide Stocks 7
Savings is a Flow Chapter Saving 9: and Capital Formation A measure that is defined per unit of time (e.g., Mr. A saves $100/month; Mrs. B saves $50/wk, etc.) Wealth is a Stock A measure that is defined at a point in time (e.g., Mr. A’s wealth was $3030 on Jan 1, 2008) Bathtub analogy Every dollar a person saves adds to his/her wealth The flow of saving causes the stock of wealth to change.
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Savings, Capital Gains and Losses Slide 8
Capital Gains - increase in the value of Chapter Saving 9: and Capital Formation existing assets - may decrease the urge to save. Eg., higher value of a stock. Capital Losses - decrease in the value of existing assets - may increase the urge to save. Eg., decrease in house prices. Capital gains and losses are not part of savings. They are part of wealth. Change in Wealth =
Saving + Capital gains - Capital loss
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Mr. A’s Balance Sheet After An Slide
Increase in the Value of His Stocks 9 Chapter Chapter Saving 9: and Capital Formation Assets Liabilities Cash $ 80 Student loan $3,000 Checking account 1,200 Credit card balance 250 Shares of stock 1,500 Car (market value) 3,500 Furniture (market value) 500 ______Total $6,780 $3,250 Net worth $3,530
Mr. A enjoyed a Capital Gain of $500 (his stock value increased from $1,000 to $1,500. Therefore his Assets increased by $500 while his liabilities remained unchanged. So his Wealth increased by $500.
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Who Saves? Slide 10
Households, Businesses and Governments. Chapter Saving 9: and Capital Formation
Household S is also called Personal S
Private S = Household S + Business S
Public S = Govt. S
Total S = Private S + Public S
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Household Saving Rate inSlide 11
the United States, 1960 - Chapter Chapter Saving 9: and Capital Formation 2006
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Low and Declining Household Slide Savings in the US 12
Household savings declined since mid 1980s Chapter Saving 9: and Capital Formation
In 2006 we saved about 0.4% of disposable income US rates are low compared to other countries Low household saving can be offset by savings of businesses or government National savings has also declined although less significantly than household savings
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US National Saving Rate, 1960Slide - 2010 13
1960: National saving was 21% of GDP; 2010: Chapter Saving 9: and Capital Formation National Saving is 11% of GDP
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC The Three Components of National Slide
Saving, 1960- 2006 14 Chapter Chapter Saving 9: and Capital Formation
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US Savings – A Global PerspectiveSlide
15 Krugman Krugman Macroeconomics 2ed
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Household Saving $ Household Saving Rate Business Saving $ Government Saving $ National Saving Rate MB MC
Low Household Savings:Slide 21
National savingsUS determines a country's ability Chapter Saving 9: and Capital Formation 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, national saving rate was fairly stable Since 2002, federal government’s large deficits have contributed to a decline in the US national saving rate
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The Bull Market of the Slide 22 How did Americans increase their wealth 1990s Chapter Saving 9: and Capital Formation during the 1990s, while household savings fell? More households acquired stocks and they enjoyed enormous capital gains as stock prices rose. 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 from 2000 - 2006
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Slide The Bull Market of the 23
1990s Chapter Saving 9: and Capital Formation
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Reasons: Why has Household Savings Slide Fallen? 24 Aging of the US population – increased fraction of the population with higher Chapter Saving 9: and Capital Formation propensities to consume Financial Innovations (derivatives) and deregulation of the financial sector – facilitated novel ways of borrowing and hence reduction in precautionary saving Capital Gains from booming stock and housing markets – Wealth effect Low interest rates – stimulating consumption through inter-temporal substitution; So Why?
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Other Reasons? Income Inequality Slide 25 Can polarization of incomes explain a rising consumption–income ratio? Chapter Saving 9: and Capital Formation Frank (2005) argues that household consumption is increasingly about positional goods – houses, cars – creating a consumption arms-race, which leads to escalating consumption relative to income. *** (next page)(Catch-up With Jones) Given the polarization of earnings in the US since the 1980s, the norms in this race are increasingly set by the super income-rich. May explain why Income Polarization leads to low S-Y ratio MB MC Which Would You Choose? Slide 26
Positional Good: World A - You will live in a Chapter Saving 9: and Capital Formation 4,000-square-feet house and others will live in 6,000-square-feet houses; OR, World B - You will live in a 3,000-square-feet house, others in 2,000-square-feet houses. Once you choose, your position on the local housing scale will persist. Non Positional Good: World C - You have 4 weeks/year of vacation time and others have 6; OR, World D, in which you would have 2 weeks of vacation, others 1 week.
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Bonus Question: Low Household Slide Saving – A Problem? 27 From a Macroeconomic perspective – not necessarily a problem. Chapter Saving 9: and Capital Formation Microeconomic Perspective – yes a problem The low household saving rate signals a problem of growing inequality in wealth among U.S. households, how? Savings patterns tend to increase this inequality as rich families save more and get richer while poor families save little and get poorer, how?
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Private Savings-Investment Identity Slide 28
Recall the basic accounting identity: Chapter Saving 9: and Capital Formation Y = C + I + G + NX, where, Y = Real income or expenditures; C = Consumption; I = Investment; G = Government Expenditure; NX = Net exports Assume G = 0 and NX = 0, closed economy and no govt. Therefore Y = C + I Private Saving equals Y – C. Therefore, S = I
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC National Saving (with Govt.) and Its Slide Components 29
Once again: Y = C + I + G + NX Chapter Chapter Saving 9: and Capital Formation Assume NX = 0, closed economy with govt.
Y = C + I + G.
Y - C = I + G, and,
Y – C – G = I
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National Saving and Its ComponentsSlide 30
National Saving (S) = Current Income (Y) minus Chapter Saving 9: and Capital Formation Spending on current needs
I = spending on capital goods, new factories, residential housing - all done to raise a nations future productive capacity; NOT spending on current needs; C includes durable goods which may satisfy current and future needs; G may also include current and future needs
Assume that all C and G are expenditures on current needs S = Y - C – G = I
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National Saving and Its ComponentsSlide 31 S = Y - C - G
Let T = taxes paid by the private sector to the Govt. minus Chapter Saving 9: and Capital Formation transfer payments and interest payments made by the govt. to the private sector on government bonds
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
Sprivate = Household S (or Personal S) + Business S
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Again: Household and Business Slide Savings 32
Private saving is done by households and Chapter Saving 9: and Capital Formation businesses Household saving or personal saving is done by families and individuals Business saving makes up the majority of private saving in the US Business saving is revenues less operating costs less dividends to shareholders Business saving can purchase new capital equipment
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Public Saving and the Government Slide Budget – Federal State and Local33
Government Budget Surplus Chapter Saving 9: and Capital Formation
The excess of government tax collections over government spending (T - G)
The government budget surplus equals public saving Government Budget Deficit
The excess of government spending over tax collections (G - T) Balanced Budget occurs when G = T.
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC A Budget Surplus Slide
34 Krugman Krugman Macroeconomics 2ed
Total investment spending is assumed to be $500 billion, $400 billion of which is financed by private savings. The remaining $100 billion comes from the budget surplus.
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A Budget Deficit Slide
35 Krugman Krugman Macroeconomics 2ed
Budget deficit = $100 billion. The budget deficit has absorbed part of private savings, which must now be $200 billion greater than it had been—$600 billion—in order for total savings to provide $500 billion in investment spending for this economy.
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Government Saving: Budget SurplusSlide 36
Federal Government (billions of dollars) 2000 Chapter Saving 9: and Capital Formation Receipts $2,053.8 Expenditures 1,864.4 State and Local Governments Receipts 1,319.5 Expenditures 1,269.5
Federal Government: Budget Surplus of $189.4 billion
State and Local Government: Budget Surplus of $50 billion
Total Budget Surplus = Public Saving = $239.4 billion
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Negative Government Saving:Slide A Budget Deficit 37
Federal Government (billions of dollars)2006 Chapter Saving 9: and Capital Formation Receipts $2,495.8 Expenditures 2,715.8 State and Local Governments Receipts 1,797.7 Expenditures 1,773.0
Federal Government: Budget Deficit of $220 billion (or a Budget Surplus of (-)$220 billion)
State and Local Government: Budget Surplus of $24.6 billion
Total Budget Surplus = Public Saving = (-) $195.4 billion Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC
From Surplus to DeficitSlide 38
Three reasons for change in government Chapter Saving 9: and Capital Formation budget
Government receipts decreased during the 2001 recession Lower income during recession means lower taxes collected
Tax reductions during the first Bush term
Government spending increased Wars in Iraq and Afghanistan Homeland Security
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC National Saving and Its Components: Slide Open Economy with Govt. 39
Y = C + I + G + NX Chapter Chapter Saving 9: and Capital Formation Assume an open economy with govt.
Y – C – G = I + NX
Recall that Domestic Savings S = Y – C – G.
So, S = I + NX (Intuition?)
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Trade Balance and Capital Outflows Slide 40 Our involvement in world market for goods and services involves: Chapter Saving 9: and Capital Formation Trade Balance = Net Exports = X – M; Trade surplus implies (X – M) >0; Trade deficit implies (X - M) <0. Our involvement in world financial markets involves: We can buy (acquire) foreign assets Capital Outflow (CO), or, Foreigners can buy (acquire) our assets Capital Inflow (CI) Net Capital Outflow NCO = CO - CI
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NX = NCO Slide 41
For an economy, NX should equal NCO. Every Chapter Saving 9: and Capital Formation international transaction involves exchange. When a seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for the good or service. Thus, the net value of the goods and services sold by a country (net exports) must equal the net value of the assets acquired (net capital outflow).
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NCO = NX Slide 42
For an open economy, NCO must be equal to NX. Chapter Chapter Saving 9: and Capital Formation Say you sell a software to a Japanese firm. The firm pays you 10,000 Yen. The value of the software is added to US NX The 10,000 Yen is added to net capital outflow because you essentially have bought a Japanese asset worth 10,000 Yen (and paid for it with your exports). S = I + NX = I + NCO, where NX = (X - M) S + Net Capital Inflow = I
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC The Savings–Investment Spending Identity in Slide an Open Economy 43
For an open economy, Domestic Investment Chapter Saving 9: and Capital Formation spending can not only be financed by national saving but also by the savings of foreigners – called Net Capital Inflow. https://www.khanacademy.org/economics- finance-domain/macroeconomics/forex-trade- topic/current-capital-account/v/why-current- and-capital-accounts-net-out
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC The S - I Identity in Open Economies: the United States, 2003 Slide
44 Krugman Krugman Macroeconomics 2ed
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC The S - I Identity in Open Economies: Japan, 2003 Slide
45 Krugman Krugman Macroeconomics 2ed
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Why Do Households Save? Slide 46
Life-Cycle Saving: Saving to meet long-term objectives - retirement, college attendance, the purchase of a home Chapter Saving 9: and Capital Formation
Precautionary Saving: Saving for “a rainy day” - loss of a job, a medical emergency
Bequest Saving: Saving for the purpose of leaving an inheritance - small business, farms, wealthy individuals
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Example: Household Savings in Slide Japan 47 After World War II, household saving rates were Chapter Saving 9: and Capital Formation 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 (working age pop has fallen and so has the savings rate) Housing prices and down payment requirements were very high Property values decreased after 1990 Bequest saving matters; precautionary saving is low
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Why Do US Households Save So Little? Slide 48
Savings rate may be depressed by Chapter Saving 9: and Capital Formation 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 (positional) goods
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Savings Rate and Future Slide Standards of Living 49
Two otherwise Chapter Saving 9: and Capital Formation identical families have different savings rates Higher savings Spends Thrifts reduces current consumption Savings Rage 5% 20% Thrifts consume Start Date 1980 1980 $32,000 in 1980 and Spends consume End Date 2015 2015 $38,000 Real Income $40,000 $40,000 Thrifts’ income grows faster Real Interest 8% 8% From 1995 on, Thrifts consume more than Spends
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Income Paths Slide 50
Income is $40,000 per year and rising because some of Chapter Saving 9: and Capital Formation the income is being saved and it is earning compound interest.
t t YS(t) = X(1+0.05r) = X(1+0.004) t t YT(t) = X (1+0.2r) = X (1+0.016)
where X = Initial income = $40,000, r=0.08 and t = 0 for 1980.
In 1981,
1 YS(1) = 40,000 (1+0.004) = $40160 1 YT(1) = 40,000 (1+0.016) = $40,640
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Income Slide 51
By 2015, t = 35 Chapter Saving 9: and Capital Formation 35 YT(35) = 40,000 (1+0.016) = $69,717 35 YS(35) = 40,000 (1+0.004) = $45,998 In 2015 the Thrifts earn 23,717 more than the Spends.
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t t Chapter Saving 9: and Capital Formation CS(t) = 0.95X (1+0.05r) = 0.95X (1+0.004) t t CT(t) = 0.8X (1+0.2r) = 0.8X (1+0.016)
where X = Initial income = $40,000, r=0.08 and t = 0 for 1980.
In 1981,
1 CS = 0.95x40,000x(1+0.004) = $38,152 1 CT = 0.8x40,000x(1+0.016) = $32,512
In 1981, the Thrifts consume $5,640 less than the Spends.
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Consumption Paths Slide 53
Fortunes turn by 2015. Chapter Saving 9: and Capital Formation 35 CT(t) = 0.8X (1+0.016) = $55,774 35 CS(t) = 0.95X (1+0.004) = $43,698 In 2015, the Thrifts consume $12,000 more than the Spends.
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Consumption Paths Slide
54 Chapter Chapter Saving 9: and Capital Formation
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t Chapter Saving 9: and Capital Formation t SS(t) = YS(t) - CS(t) = X (1+0.004) - 0.95X (1+0.004) = 0.05X (1+0.004)t
t ST(t) = YT(t) - CT(t) = 0.2X (1+0.016)
where X = Initial income = $40,000, and t = 0 for 1980.
In 1981,
1 SS = 0.05x40,000x(1+0.004) = $2,008 1 ST = 0.2x40,000x(1+0.016) = $8,128
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC S = Y - C Savings Paths: Slide 56
Fortunes turn by 2015. Chapter Saving 9: and Capital Formation 35 ST(t) = 0.2X (1+0.016) = $13,943 35 SS(t) = 0.05X (1+0.004) = $2,300 In 2015, the Thrifts save $11,643 more than the Spends. High Savings pays off handsomely in the long run because of the power of compounding.
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Investment and Capital Slide Formation 57
Investment Chapter Chapter Saving 9: and Capital Formation 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.
Firms undertake investment spending if it is expected to be profitable (i.e., the benefit, or value of the marginal product of capital exceeds the cost of capital)
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Digression: Three Kinds of Capital Slide 58
Physical Capital Chapter Chapter Saving 9: and Capital Formation Manufactures resources like buildings and machines
Improvement in the labor force generated by education and knowledge
Funds from Savings that are available for Investment Spending
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Larry and the lawn Mower Slide 59
Example: Should Larry buy a riding lawn mower? Chapter Saving 9: and Capital Formation Cost of lawn mower = $4,000 Interest on loan = 6% Net revenue = $6,000/year Taxes = 20% Larry could earn $4,400/year after tax elsewhere Assume the mower can be resold for $4,000
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Larry and the Lawn Mower Slide
60 Chapter Chapter Saving 9: and Capital Formation Should Larry buy a riding lawn mower? 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
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The Investment Decision: cost v.sSlide Benifit 61
Two important costs Chapter Saving 9: and Capital Formation 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
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Saving and Real Interest Rates Slide 62
Two effects on Savings of a higher real Chapter Saving 9: and Capital Formation interest rate r:
Substitution effect: Increases the return on savings and the opportunity cost of consumption: r S
Wealth (Income) effect: Increases wealth; reduces the S needed to achieve goals: r S
Generally Sub. effect > Wealth effect
Empirically, r S
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Saving, Investment, and Financial Slide Markets 63
Supply of Savings (S) Chapter Saving 9: and Capital Formation
The quantity supplied of saving is positively related to the real interest rate (r)
Demand for Saving (I)
The quantity demanded for saving is negatively related to the real interest rate r.
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Saving, Investment, and Financial Slide
Markets 64 Chapter Chapter Saving 9: and Capital Formation Market for Savings
The market 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.
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC The Supply and Demand For Savings Slide
65 Chapter Chapter Saving 9: and Capital Formation Saving S
r Real interestReal rate (%) Investment I
S, I Saving and investment
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC The Effect of a New Technology Slide on National Saving and Investment 66
S Chapter Saving 9: and Capital Formation
New Technology •Raises the marginal F r’ productivity of E capital r •This increases the demand for capital
Real interestReal rate (%) andI’ hence I investment funds
Saving and investment
Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. MB MC Increase in the Government Slide Budget Deficit – Crowding Out 67 S’
S Chapter Saving 9: and Capital Formation
Increases in the F government budget r’ E deficit: r •Reduces S public and national saving •r will increase
Real interestReal rate (%) I •S & I will fall •This is Crowding Out
Saving and investment
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68 Chapter Chapter Saving 9: and Capital Formation Crowding Out
The tendency of govt. budget deficits to reduce Investment spending is called Crowding out.
This leads to lower capital formation and eventually a lower rate of economic growth.
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How Can We Increase NationalSlide Saving 69
Policymakers know the benefits of increased national Chapter Saving 9: and Capital Formation saving rates Reducing government budget deficit would increase national saving
Political problems Increase incentives for households
Federal consumption tax – tax on income spent on consumption
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
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Summary