9af23c07-bd6d-417b-b86d-1d399de9cbc4.doc Page 1 of 3 Jack Muryn Chapter 22 Outline: Saving and Capital Formation I. Introduction/Overview A. Saving is important both to individuals and to nations. 1. People need to save for retirement and other future needs, and to provide an emergency fund. 2. At the national level, saving provides the resources for the production of new capital goods, which is an important factor promoting economic growth. 3. Because adequate saving is so important, people have expressed concern about the low saving rate of American households. B. National saving is comprised of household and other forms of saving; while household saving has declined dramatically in recent decades, the total saving of the U.S. economy has not declined significantly in recent years. Saving and Wealth A. The saving of an economic unit can be defined as its current income minus its spending on current needs. 1. The saving rate of any economic unit is its saving divided by its income. 2. Saving is closely related to wealth, or the value of assets minus liabilities. a. Assets are anything of value that one owns, either financial or real. b. Liabilities are the debts one owes. c. Using a balance sheet we can compare an economic unit’s assets and liabilities and find its net worth. 3. Saving contributes to wealth. B. Stocks and Flows 1. Saving is a flow, a measure that is defined per unit of time. Often, it is the rate of change in a stock. 2. Wealth, in contrast, is a stock. 3. Higher rates of saving today lead to faster accumulation of wealth, and the wealthier a nation is, the higher its standard of living. C. Capital Gains and Losses 1. Saving is not the only factor that determines wealth; wealth can also change because of changes in the values of the real or financial assets one owns. 2. When an asset’s value increases it is called a capital gain (wealth increases); when it decreases it’s called a capital loss and wealth decreases. 3. Capital gains and losses are not counted as part of saving; instead, the change in wealth in a period is the saving plus any capital gains (or minus any capital losses). Why Do People Save? 1. There are at least three broad reasons for saving: a. to meet long-term objectives (life-cycle saving) b. protection against unexpected setbacks (precautionary saving) c. to leave to one's heirs (bequest saving) A. Saving and the Real Interest Rate 1. The rate of return that is most relevant to saving is the real interest rate, which is the market interest rate minus the inflation rate. 2. The example of the “Spends” and the “Thrifts” illustrates that a high savings rate can greatly enhance a family’s future living standard. B. Saving, Self-Control, and Demonstration Effects II. III. 9af23c07-bd6d-417b-b86d-1d399de9cbc4.doc Page 2 of 3 Jack Muryn 1. Many psychologists have argued that people’s saving behavior is based as much on psychological factors as on economic factors. 2. For example, psychologists stress that many people lack the self-control to do what they know is in their own best interest (counter to the idea of rational decision-making). a. automatic saving through payroll savings plans can help strengthen self-control b. this also implies that consumer credit arrangements that make borrowing and spending easier may reduce the amount that people save 3. Downward pressure on the saving rate may also occur when additional spending by some consumers stimulates additional spending by others. a. These are called demonstration effects; they occur when people use the spending of others as a yardstick by which to measure the adequacy of their own living standards. b. When satisfaction depends on relative living standards, an upward spiral may result in which household spending is higher and saving lower than would be best for either the individual families involved or for the economy as a whole. IV. National Saving and Its Components The Measurement of National Saving 1. To define the saving rate of a country as a whole we start with the basic identity Y = C + I + G + NX 2. If we assume that NX is zero, then Y = C + I + G 3. Treating all consumption spending and government purchases as spending on current needs, then national saving is S = Y – C - G a. As the text notes, it is difficult to decide how much of C and G should be counted as spending on current needs, so this is a simplifying assumption. Private and Public Components of National Saving 1. Private saving is the amount households and businesses save from private-sector income. 2. Public saving is the amount governments save from public-sector income. 3. Transfer payments are the payments the government makes to the public for which it receives no current goods or services in return. 4. Private saving is equal to the after-tax income of the private sector minus consumption expenditures (Y – T – C) a. Private saving can be broken down into saving done by households (household saving) and saving done by businesses. b. Household saving, also called personal saving, corresponds to the familiar idea of people setting aside part of their incomes. c. Business saving makes up the bulk of private saving in the United States. It is the funds remaining after businesses pay their costs. 5. Public saving is the amount of the public sector’s income which is not spent on current needs. a. The public sector includes the state and local governments as well as the federal government. b. Public saving is public sector income (net taxes, T) less government spending, G. C. Public Saving and the Government Budget 1. Public saving is closely linked to the government’s decisions about spending and taxing. 2. If taxes and spending are equal in any given year, the government is said to have a balanced budget. If spending is greater than taxes, it has a government budget deficit and if spending is less than taxes it has a government budget surplus. 3. Public saving is the same as a government budget surplus. 9af23c07-bd6d-417b-b86d-1d399de9cbc4.doc Page 3 of 3 Jack Muryn 4. If the government has a government budget deficit it must make up the difference by borrowing from the public by issuing new government bonds. 5. The government’s budget went from a surplus to a deficit in the early 2000s due to: a. the recession that began in 2001; b. the reduction in tax rates c. the increase in government expenditures D. Is Low Household Saving a Problem? 1. From a macroeconomic perspective, the problem posed by low household saving has probably been overstated. 2. The key fact is that national saving, not household saving, determines the capacity of an economy to invest in new capital goods and to achieve continued improvement in living standards. 3. From a microeconomic perspective, the low household saving rate does signal a problem, which is the large and growing inequality in wealth among U.S. households. V. Investment and Capital Formation 1. National saving provides the funds needed for investment. 2. Firms acquire new goods because such investment is profitable. 3. Firms’ willingness to acquire new factories and machines depends on the expected benefit of using them exceeding the expected cost of using them. 4. On the cost side, two important factors in the decision to invest are a. the price of capital goods and b. the real interest rate (the financing cost if the funds are borrowed; the lost interest if they are not) 5. On the benefit side, the key factor is the value of the marginal product of new capital, which should be calculated net of both operating and maintenance expenses and taxes paid on the revenue the capital generates. Saving, Investment, and Financial Markets 1. Financial markets work to equalize the supply of saving (by households, firms, and the government) and demand for saving (by firms that want to purchase or construct new capital). 2. In the graph showing market the saving curve is upward-sloping because increases in the real interest rate stimulate saving. 3. The demand is shown as a downward-sloping curve because higher real interest rates increase the cost of borrowing and reduce firms’ willingness to invest. 4. In equilibrium, desired investment must equal desired national saving. 5. The real interest rate functions as a price, clearing the market for saving as prices do in other markets. 6. Changes in factors other than the real interest rate that affect the supply of or demand for saving will shift the curves, leading to a new equilibrium in the financial market. 7. Factors affecting supply and demand: a. The effects of new technology: new technology increases the marginal product of new capital, increasing the demand for saving and causing the real interest rate to rise. b. An increase in the government budget deficit results in a decrease in national saving, causing the saving curve to shift to the left and the real interest rate to rise. c. The tendency of government budget deficits to reduce investment spending is called crowding out. VI.