Savings and Capital Formation Overview

Savings and Capital Formation

• Savings is current income less spending on current needs.
• Saving rate is saving divided by income.
• Household saving is income minus spending on consumption, depreciation, and taxes.
• Firm saving is income from sales and transfers minus spending on wages, raw materials, rent, dividends, and taxes.
• Government saving is tax revenue minus government purchases and transfers.
• Key motives for saving include life-cycle saving, precautionary saving, and bequests.
• Life-cycle saving is saving for predictable events like a home deposit or retirement.
• Precautionary saving is saving for unpredictable events like job loss or a medical emergency.
• Bequests are savings passed on to the next generation.
• National savings is the sum of private savings and public savings.
• National savings equal investment in a closed economy.
• Physical capital is a stock, while investment is a flow.
• Net capital accumulation is investment less depreciation.
• The real interest rate is determined by the intersection of the saving supply and investment demand curves.
• The supply of saving is positively related to the real interest rate.
• The demand for investment is inversely related to the real interest rate.
• The equilibrium real interest rate equates the supply and demand for savings.
• Shocks to the determinants of savings and investment can affect the equilibrium real interest rate and quantities of savings and investment.
• New technology increases investment demand, leading to higher equilibrium real interest rates, savings, and investment.
• An aging population decreases savings supply, leading to higher equilibrium real interest rates with lower savings and investment.

Stocks and Flows

• Flow variables are measured per unit of time, like income, saving, GDP, and consumption.
• Stock variables are measured at a point in time, like wealth and capital.
• The change in a stock is a flow, and a stock is the sum of past flows.

Aside: Keynes and the Classics

• The savings and investment model discussed is a classical model for understanding long-run trends.
• Keynesian economics, by contrast, focuses on short-run fluctuations using an income-dependent savings function.

Basic Savings and Investment Concepts

• Saving: Current income less spending on current needs.
• Saving Rate: Saving divided by income.

Key Motives for Saving

• Life-cycle saving: Savings against predictable events, like retirement or purchasing a home.
• Precautionary saving: Savings against unpredictable events, like job loss or medical emergencies.
• Bequests: Saving for the next generation.

National Saving

• National Income Accounting Identity: Y = C +I +G (Y = Output, C = Consumption, I = Investment, G = Government Spending)
• Private Savings (S): Disposable income less consumption: (Y − T ) − C.
• Public Saving (T - G): Government revenue (T) minus government spending (G).
• National Savings (NS): Private saving plus public saving: S + T − G.
• Closed Economy: National savings equals investment: NS = I

Capital and Investment

• Physical Capital: Stock of plant, equipment, etc. at a given time (Kt).
• Investment: Expenditure on plant, equipment, etc. per unit time (It).
• Depreciation: Value of depreciated capital is δKt where δ is the depreciation rate per unit time.
• Net capital accumulation: Kt+1 − Kt = It − δKt.

Equilibrium Real Interest Rate

• Supply of Loanable Funds (S(r)): Increasing in the real interest rate (r), representing how much people are willing to save at each interest rate.
• Demand for Loanable Funds (I(r)): Decreasing in the real interest rate.
• Equilibrium Real Interest Rate (r):* S(r*) = I(r*), the rate where saving and investment demand are equal.

Examples of Shocks

• New Technology: Increases investment demand (I(r) shifts right). Equilibrium real interest rate and savings and investment increase.
• Ageing Population: Decreases savings supply (S(r) shifts left). Equilibrium real interest rate and savings and investment decrease.

Savings and Capital Formation

• Savings is defined as current income less spending on current needs.
• Savings rate is savings divided by income.
• Key motives for saving: life-cycle saving, precautionary saving, bequests.
• Life-cycle saving involves saving for predictable events, like retirement.
• Precautionary saving involves saving for unpredictable events, like job loss.
• Bequests involve saving for the next generation.
• In a closed economy, national saving equals investment.
• National saving is the sum of private savings and public savings.
• Private saving is disposable income less consumption.
• Public saving is taxes less government spending.
• Flow variables are measured per unit of time (e.g., wage per fortnight).
• Stock variables are measured at a point in time (e.g., value of assets).
• The change over time in a stock is a flow (e.g., change in capital stock is investment).
• Capital is a stock, representing the value of plant and equipment.
• Investment is a flow, representing expenditure on plant and equipment.
• Depreciation is the rate at which capital depreciates per unit time.
• Net capital accumulation is the difference between investment and depreciation.
• Equilibrium real interest rate is the rate at which the supply of savings equals the demand for investment.
• The supply of savings (S(r)) is increasing in the real interest rate.
• The demand for investment (I(r)) is decreasing in the real interest rate.
• The classical model focuses on long-run trends, while the Keynesian model focuses on short-run fluctuations.
• A technological breakthrough that increases investment demand will shift the I(r) curve out, leading to a higher real interest rate and higher equilibrium levels of investment and savings.
• An aging population that decreases savings will shift the S(r) curve in, leading to a higher real interest rate and lower equilibrium levels of investment and savings.

Learning outcomes

• Explain basic concepts in relation to savings, its definition, savings rate and motives for saving
• Understand basic concepts in relation to investment, including the relationship between stocks and flows and how to derive a mathematical expression for net capital accumulation.
• Understand how the real interest rate is determined in a simple classical loans market model.
• Critically assess the applicability of a simple classical loans market model to different time horizons.
• Explain how shocks to the determinants of savings and investment will alter the real interest rate and quantities of savings and investment in equilibrium.

Savings and Investment Concepts

• Saving is current income less spending on current needs.
• Household saving includes income from wages, interest, dividends, and transfers, and spending on consumption of goods and services, depreciation, and taxes.
• Firms’ income includes sales of goods and services and transfers, and their spending includes wages, raw materials, rent, dividends, and taxes.
• Government income includes taxes from households and firms, and their spending includes government purchases and transfers.
• Saving Rate: Saving divided by income.

Key Motives for Savings

• Life-cycle Saving: Saving for predictable events, such as retirement or a house deposit, and paying off outstanding loans
• Precautionary Saving: Saving for unpredictable events, such as job loss or medical emergencies.
• Bequests: Saving for the next generation.

National Savings

• National Income Accounting Identity: Y = C + I + G
• Private Savings (S): S = (Y - T) - C = I + G - T (Disposable income less consumption)
• National Savings (NS): NS = S + T - G = I (Private saving plus public saving)
• Closed Economy: National Savings equals Investment.

Stocks and Flows

• Flow Variables: Measured per unit of time (e.g., wages per fortnight or GDP per year).
• Stock Variables: Measured at a point in time (e.g., assets or physical capital stock).

Capital and Investment

• Physical Capital (Kt): Stock variable representing the value of plant and equipment at a point in time.
• Investment (It): Flow variable representing expenditure on plant and equipment per unit of time.
• Depreciation Rate (δ): The rate at which capital depreciates per unit of time (δKt).
• Net Capital Accumulation: Kt+1 - Kt = It - δKt.
• Capital Stock at Time t+1: Kt+1 = (1 - δ)Kt + It.

Equilibrium Real Interest Rate

• The equilibrium real interest rate (r)* is determined by the intersection of the supply of savings (S(r), increasing in r) and the demand for investment (I(r), decreasing in r).
• Factors influencing the supply of savings: Life-cycle considerations, precautionary motives, and bequests.
• Factors influencing the demand for investment: The availability of profitable investment projects, the cost of borrowing, and the expected rate of return on investments.

Examples of Shocks to Savings and Investment

• New Technology: Increases investment demand, shifting the I(r) curve outward; results in a higher equilibrium real interest rate and higher levels of both savings and investment.
• Ageing Population: Decreases savings supply, shifting the S(r) curve inward; results in a higher equilibrium real interest rate and lower levels of both savings and investment.

This quiz explores the concepts of savings and capital formation, including definitions and key motives for saving. It covers different types of savings, such as household, firm, and government savings, and explains the relationship between national savings and investment. Test your knowledge on the importance of savings in economic contexts.