Lecture 5: Saving and Capital Formation PDF

Lecture 5 Saving and Capital Formation 2 ▸ Saving ▸ Why do individuals choose to save? Lecture ▸ National saving: collective saving of Outline households, businesses, and government ▸ Capital formation ▹ How do firms decide...

Lecture 5 Saving and Capital Formation 2 ▸ Saving ▸ Why do individuals choose to save? Lecture ▸ National saving: collective saving of Outline households, businesses, and government ▸ Capital formation ▹ How do firms decide to invest in new capital? ▸ Supply and demand for savings 3 Saving 4 ▸ Saving: current income minus spending on current needs ▸ Example: Saving ▹ Elaine earns $4,000 a month ▹ Spends $3,600 a month on living expenses ▹ Saving: $4,000 - $3,600 = $400 a month ▹ Saving rate: $400/$4,000 = 10% ▸ Why does Elaine save? ▸ What are the factors that influence her saving rate? 5 1. Life-cycle saving is to meet long-term objectives ▹ Retirement ▹ Purchase a home Three ▹ Children’s university education Reasons 2. Precautionary saving is for protection for against setbacks Household ▹ Loss of job Saving ▹ Medical emergency 3. Bequest saving is to leave an inheritance 6 ▸ Real interest rate is the “reward” for saving ▹ Real interest rate (r) is nominal interest rate (i) minus rate of inflation (π) ▹ More willing to save if reward is higher ▹ Positive effect on saving Real ▸ However, higher interest rate reduces the Interest amount people need to save to reach their Rate specific goal; target savers affecting ▹ The higher the real interest rate, the faster Saving one’s saving will grow Rate ▹ Negative effect on saving ▸ Empirical evidence shows that higher real rates increase saving modestly 7 ▸ Degree of self-control ▹ Saving requires postponement of current consumption ▹ E.g. weekend trip to Bangkok vs saving for retirement Psycho- ▹ For people with self-control problems, logical financial arrangement such as automatic Factors payroll savings plan can help to increase affecting saving Saving ▸ Demonstration effect Rate ▹ People feel compelled to spend at the same rate as their friends/neighbours, even though they may not be able to afford to do so 8 ▸ Chinese households save about 25% of disposable income, a very high rate ▹ This is new: was only 10% until late 1980s ▹ Before reforms, less ability and less need Household for precautionary saving Saving in ▸ Life-cycle and precautionary motives are China important ▹ Wealth has come recently to China; young people richer than older people; saving of young outweighs dissaving of old ▹ Limited social safety net ▹ Little opportunity for individuals to borrow, saving are necessary for large purchases such as paying for a house 9 ▸ Household saving rate has always been low by international standards; between 6 and 8 percent in the recent years ▸ Saving rate may be depressed by Household ▹ Social Security, Medicare, and other Saving in government programs for the elderly the U.S. ▹ Mortgages with small or no down payment ▹ Confidence in a prosperous future ▹ Increasing value of stocks and growing home values ▹ Demonstration effects: imitation of consumption patterns of other people 10 Measurement of National Saving 11 ▸ Key concepts: 1. National saving is current income minus spending on current needs Measuring National 2. A country's national saving is the Saving total of private saving (by households and firms) and public saving (by the government) 12 ▸ National saving (S) is current income less spending on current needs ▹ Current income is GDP or Y ▹ Spending on current needs is C + G Measuring Most consumption and government National spending is for current needs; for Saving simplicity, all of C and all of G are assumed to be for current needs Investment spending (I) is excluded S=Y–C–G 13 National Saving, S Components of National Saving Household Business Government Saving Saving Saving Private Saving Public Saving 14 ▸ Private saving: household saving plus business saving ▹ Household saving or personal saving is done Private by families and individuals Saving ▹ Business saving makes up the majority of private saving in the U.S. ▹ Business saving = Revenues – Operating costs – Dividends to shareholders 15 ▸ Private sector's total income is Y ▸ Private sector pays taxes to the government, and receives transfer payment and interest Private payment (for government bond holders) from Saving the government ▸ Net Taxes, T = Taxes – Transfers – Govt interest payments ▸ Y-T is after-tax income (or disposable income) ▸ Private saving is after-tax income less consumption SPRIVATE = Y – T – C 16 ▸ Public saving is the amount of ▹ Government income (net taxes, T) minus ▹ Government spending on current needs (G) Public SPUBLIC = T – G Saving ▸ Net taxes (T) minus government spending (G) is also Government budget balance ▹ T = G: balanced budget ▹ T > G: Govt budget surplus Budget surplus is public saving ▹ T < G: Govt budget deficit Budget deficit is public dissaving 17 ▸ National saving, S = Y – C – G Summary ▸ S = SPRIVATE + SPUBLIC ▸ SPRIVATE = Y – T – C ▸ SPUBLIC = T – G 18 Three Components of National Saving, 1960- 2022 19 Capital Formation (aka Investment) 20 ▸ Investment is the creation of new capital goods and housing ▸ Most decisions to invest in new capital Investment are made by firms ▸ What factors determine whether and how much firms choose to invest? ▹ Cost-Benefit Principle ▹ Cost is the cost of using new machines ▹ Benefit is the value of the marginal product of new machines 21 ▸ Lauren's lawn care business plan ▹ Cost of lawn mower = $4,000 Interest on loan = 6% Assume the mower can be resold for Lauren $4,000 and the ▸ Net revenue = $6,000 per summer Lawn ▹ Taxes = 20% Mower ▹ Lauren could earn $4,400 per summer after tax working elsewhere ▸ Cost-Benefit Principle indicates whether Lauren should start the business 22 ▸ Business plan analysis Net revenue $6,000 Financial Less taxes (20%) $1,200 benefit of Lauren Less opportunity cost $4,400 buying the mower and the Equals VMP of lawnmower $ 400 Lawn Less interest (6%) $ 240 Mower Equals net benefit $ 160 Financial cost of buying the ▸ Lauren should start the business mower 23 ▸ Two important costs ▹ Price of the capital goods Higher prices increase cost ▹ Real interest rates Cost and Higher real i/r increases costs Benefit of ▸ Benefit is the value of the marginal product of the capital Investment ▹ Net of operating and maintenance Decision expenses and taxes ▹ Technical innovation increases MP of capital → increases benefits ▹ Lower taxes increase benefits ▹ Higher relative price of the output increases benefits 24 Supply and Demand for Savings 25 ▸ Supply of savings (S) is the amount of savings that would occur at each possible real interest rate (r) ▹ Savings are supplied by households, firms, and Financial the government Market ▹ The quantity supplied increases as r increases (Market for ▸ Demand for savings (or investment (I)) is the Savings) amount of savings borrowed at each possible real interest rate ▹ Savings are demanded by borrowers wishing to invest in new capital goods ▹ Demand for savings = demand for investment ▹ The quantity demanded is inversely related to r 26 ▸ In the absence of international borrowing or Saving S lending, supply of and demand for national Real interest rate (%) Financial saving must equal Market ▸ Equilibrium interest rate equates quantity of saving r with quantity of investment funds Investment I demanded ▸ Changes in factors other than real interest rates will S, I shift the savings or Saving and investment investment curves 27 S ▸ New technology raises marginal productivity of capital Real interest rate (%) ▹ Increases the Technological F demand for r' Improvement E investment funds r ▹ Movement up the I' savings supply curve I ▹ Higher interest rate ▹ Higher level of savings and investment Saving and Investment 28 ▸ Government budget S' deficit increases S ▹ Reduces national Real interest rate (%) saving Government F ▹ Movement up the Budget r' E investment curve Deficit r ▹ Higher interest rate Increases ▹ Lower level of I savings and investment ▸ Private investment is crowded out Saving and investment 29 THANKS! 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