Chapter 7

Savings and Investment Savings and Investment ProcessProcess

© 2011 John Wiley and Sons

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Chapter Outcomes

Identify and briefly describe the major components of the gross domestic product

Describe how the balance between exports and imports affects the gross domestic product

Describe recent developments in the aggregate level of personal and corporate savings

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Chapter Outcomes(Continued)

Describe the principal sources of federal government revenues and expenditures

Discuss the historical role of savings in the United States and how savings are created

Identify the major sources of savings in the United States

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Chapter Outcomes(Concluded)

Identify and describe the factors that affect savings

Describe the major capital market securities that facilitate the savings and investment process

Discuss the role of individuals in the recent financial crisis

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Gross Domestic Product (GDP) and Capital Formation

Gross Domestic Product:: Measures the output of goods and services in an economy over a specified time period

Capital Formation:: Process of constructing real property, manufacturing producers’ durable equipment, and increasing business inventories

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Gross Domestic Product (GDP) Components

GDP is composed of: Personal Consumption Expenditures Government Expenditures including

Gross Investment Gross Private Domestic Investment Net Exports of Goods and Services

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Gross Domestic Product (GDP) Components (continued)

Equation::

GDP = PCE + GE + GPDI + NE Personal Consumption Expenditures

(PCE):): Expenditures by individuals for durable goods, nondurable goods, and services

Government Expenditures (GE): : Purchases of goods and services by the government

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Gross Domestic Product (GDP) Components (continued)

Equation::

GDP = PCE + GE + GPDI + NE Gross Private Domestic Investments

(GPDI):: Investments in residential & nonresidential structures, producers’ durable equipment, & business inventories

Net Exports (NE): Exports minus imports of goods & services

Recent Gross Domestic Product (GDP) Amounts

($ Billions) 2006 2009 GDP $13,253.9 $14,258.7

PCE 9,270.8 10,092.6 GPDI 2,218.4 1,622.9 NE -761.8 -390.1 GE 2,526.4 2,933.3

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Link Between Saving and Investment

Gross Saving = Net Saving + Consumption of Fixed Capital

For 2008 (in $ Billions):

Net Saving = -$23.0

Consumption of Fixed Capital = $1,847.1

Gross Saving = $1,824.1

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Link Between Saving and Investment

Net Saving = Net Private Saving + Net Government Saving

For 2008 (in $ Billions):

Net Private Saving = $659.8

Net Government Saving = -$682.7

Net Saving (rounded) = -$23.0

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Link Between Saving and Investment

Consumption of Fixed Capital = Private + Government

For 2008 (in $ Billions):

Private = $1,536.2

Government = $310.9

Consumption of Fixed Capital = $1,847.1

Federal Government Receipts and Expenditures

1970-1997:

Annual deficit budgets 1998-2001:

Annual surplus budgets 2002-Present:

Annual deficits with fiscal 2009 and 2010 deficits each exceeding $1.0 trillion [National Debt now exceeds $12 trillion]

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Federal Government Dollar:Fiscal Year 2008

Where It Comes From (Income):

--Personal Income Taxes (39%)

--Social Security and other Retirement Taxes (30%)

--Borrowing to Cover Deficit (15%)

--Corporate Income Taxes (10%)

--Excise, Estate, and other Taxes (6%)

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Federal Government Dollar:Fiscal Year 2008 (continued)

Where It Goes (Outlays): --Social Security, Medicare, and other

retirement (37%)

--National Defense, veterans, and Foreign Affairs (24%)

--Social Programs (including Medicaid)(20%)

--Physical , Human, and Community Development (9%)

--Net Interest on the Debt (8%)

--Law Enforcement and General Gov’t. (2%)

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Debt Financing

Budgetary Deficit: Occurs when expenditures are greater than revenues

Federal Statutory Debt Limits:

Limits on the federal debt set by Congress

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Historical Role of Savings in the United States

Foreign investors initially purchased large amounts of the securities sold by government & private promoters to develop the U.S.

The American family later took over the function of providing savings for the capital formation process

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Creation of Savings

Savings: Income that is not consumed but held in the form of cash and other financial assets

Savings Surplus: Occurs when current income exceeds investment in real assets

Creation of Savings

Savings Deficit:

Occurs when investment in real assets exceeds current income

Undistributed Profits:

Proportion of after-tax profits retained by corporations

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Major Sources of Savings

Personal SavingPersonal Saving::

Savings of individuals equal to personal Savings of individuals equal to personal income less personal current taxes less income less personal current taxes less personal outlayspersonal outlays

Voluntary SavingsVoluntary Savings:: Savings held or set aside by choice for future use

Contractual SavingsContractual Savings:: Savings accumulated on a regular schedule by prior agreement

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Personal Savings in the U.S.

Personal Savings Definition:: Personal income Less: taxes and other payments Equals: disposable personal income Less: personal outlays Equals: personal savings

Savings Rate DefinitionSavings Rate Definition:: Savings Rate = (Personal Savings)/ (Disposable Personal Income)

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Historical Personal Savings Rates

1960 5.8% 1965 7.0 1970 8.1 1975 9.2 1980 7.1 1985 4.5 1990 4.3 1995 4.8 2000 1.0 2005 1.4

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Corporate Savings in the U.S.

Undistributed Profits Definition: Profits before taxes Less: tax liabilities Equals: profits after taxes Less: dividends Equals: undistributed profits

Retention Rate Definition: Retention Rate = (Undistributed Profits)/(Profits After Taxes)

Corporate Savings in the U.S.

Adjustments to Corporate Profits:Nonfinancial corporate profits before taxes are often shown after (1) inventory valuation and (2) capital consumption adjustments

(1) Records estimated changes in inventory values over time

(2) Reflects the “using up,” or depreciation, of plant and equipment assets used for business purposes

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Factors Affecting Savings

Levels of income Economic expectations Cyclical Influences (economic

cycles) Life stage of the individual saver

or corporation

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Life Stages of the Individual Saver

Individual Saver:--Formative/education developing--Career starting/family creating--Wealth building--Retirement enjoying

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Life Stages of the Corporation

Corporation:--Start-up stage--Survival stage--Rapid growth stage--Maturity stage

Capital Market Securities

Capital Markets:

Markets where debt securities with maturities longer than one year and corporate stocks are issued or traded

Capital Market Securities:

Debt securities with maturities longer than one year and corporate stocks

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Major Capital Market Securities

Securities: Issuers: Mortgages Fin. intermediaries Treasury bonds U.S. government Municipal bonds State/local gov’ts. Corporate bonds Corporations Corporate stocks Corporations

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Major Capital Market Securities

Securities: Secondary Market:

Mortgages High activity Treasury bonds High activity Municipal bonds Moderate activity Corporate bonds Moderate activity Corporate stocks High activity

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Capital Market Securities Defined

Mortgage:Loan backed by real property in the form of buildings and houses

Treasury bond:Long-term debt instrument issued by the U.S. federal government

Municipal bond:Long-term debt instrument issued by a state or local government

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Capital Market Securities Defined

Corporate bond:Debt instrument issued by a corporation to raise long-term funds

Common stock:Ownership interest in a corporation

Derivative Security

Derivative Security:

Financial contract that derives its value from a bond, stock, or other asset

Use of Derivative Securities:

Corporations can use derivative securities to insure or hedge against various financial risks

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2007-09 Financial Crisis

Early Factors: 2000 -- Internet or “tech” bubble burst and

stock prices began declining rapidly 2001 -- Economic recession resulted

(exacerbated by the 9/11/2001 terrorist attacks)

2001-2002 – Monetary policy focused on providing liquidity and fiscal policy became stimulative resulting in low interest rates and economic growth

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2007-09 Financial Crisis

Borrowing-Related Cultural Shift: U.S. consumers moved from “save now,

buy later” to “spend now, pay later” with the result being increased mortgage loans and credit card borrowings

U.S. government officials encouraged wider home ownership and mortgage lenders offered adjustable-rate mortgages (ARMs) and even subprime mortgages to poorly qualified borrowers

The “housing price bubble” burst in mid-2006 and home owners began defaulting 35

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Web Links

www.bea.gov www.irs.gov www.stlouisfed.org www.federalreserve.gov