Frank & BernankeFrank & Bernanke

Ch. 10: Saving and Capital Formation

What Is Saving?What Is Saving?Saving at the household level is the amount

of current income that is not currently consumed.– Joan has an income of $1000 this month.– She buys food for $300, pays rent for $250,

buys clothes, entertainment, transportation, education for $300, contributes to a Christmas Club $30, buys $50 of her company’s stock, and adds $50 to her checking account and pays $20 she owes to Jim.

– What is her saving?

What Is Saving?What Is Saving?Saving at the household level is the amount

of income that is added to wealth.– Wealth is the net worth of individuals or

households or firms.– Net worth is defined as the difference between

assets one owns minus liabilities one owes.– Why would Joan’s $150 in savings increase her

wealth?

Net WorthNet WorthFor Joan, her net worth is the difference

between her assets and her liabilities.Her net worth is a combination of both real

and financial assets.Because Joan may experience both capital

gains and capital losses, even if she has zero savings, her net worth may change.

Saving At the National LevelSaving At the National LevelThe portion of income not spent on

consumption but spent on acquiring wealth by households, firms and governments will constitute the national saving.

If no part of national saving is used to acquire wealth abroad and no foreigner acquired assets here, then national savings will have to equal to capital formation.

What Is Capital Formation?What Is Capital Formation?Net additions to the stock of capital is

capital formation.At the household level, additions to net

worth (savings) is “capital formation.”At the national level, all the assets minus

liabilities will constitute net worth and additions to assets or reductions from liabilities will increase net worth.

What Is Capital Formation?What Is Capital Formation?Another name for capital formation is

“investment.”We basically seem to say that “savings” and

“investments” are the same.However, we want to emphasize that

investments are additions to capital stock, buildings, roads, infrastructure, machines, tools.

Savings are primarily financial (except homes).

Home ExampleHome ExampleYou buy a home that is built this year.You have $15,000 saved in bank accounts,

stocks and bonds which you use for down payment.

You borrow the remaining $85,000 from Bank.The market value of the home remains at

$100,000.Assuming that your net worth was $15,000

before you bought the house, what is it now?

Home ExampleHome ExampleThe Bank had no assets and 85 people deposited

$1000 each - liabilities of $85K and cash (assets) of $85K.

The sum of net worth for depositors is $85K.The Bank loaned you the money so it has a piece

of paper that says you owe it $85K.Its assets and liabilities are equal.The savings of the 85 people plus your $15K

bought the new house.

Home ExampleHome ExampleThe financial savings of $100,000 is used to

buy a new home.The new home is an investment worth

$100,000. It increases the capital stock of the nation.

You own 15% of the home and the savers own 85%.

Without the existence of savings, the investments couldn’t have been financed.

Savings and InvestmentSavings and InvestmentThe importance of saving and investment is

the ability to convert the financial wealth into capital stock.

The more the capital of a country, the higher is the average labor productivity.

The higher the average labor productivity, the higher is the standard of living.

Real Interest RatesReal Interest RatesReal interest rates will play a pivotal role in

affecting the decisions of 85 savers, your readiness to borrow the $85,000 and the bank’s willingness to lend the money.

There are many reasons why people save and why people invest; but real interest rates appear as one of these reasons in both cases.

Answers to Problem 1, p. 256Answers to Problem 1, p. 2561a. Corey’s balance sheet is as follows:

ASSETS LIABILITIESBike $300 Credit card debt $150Cash 200 Electric bill due 250Baseball card 400Checking acct. balance 1200

TOTAL 2100 400

Net worth 1700

Corey’s assets have value of $2100, his liabilities are $400, so his net worth is$2100 - $400, or $1700.

b. The card is worth zero rather than $400. Assets decline to $1700, liabilities areunchanged, net worth falls by $400 to $1300. This is an example of a capital loss; nosaving (positive or negative) has occurred.c. Liabilities are reduced by $150, assets are unchanged, net worth increases by$150 to $2250. Note that paying off a debt out of current income is a form of saving.d. Assets decline by $150, as the checking account balance falls from $1200 to$1050. Liabilities also decline by $150, as the credit card debt falls to zero. Net worth(assets minus liabilities) is unchanged. No saving has been done in this case, rather anexisting asset was set off against an existing liability.

Answers to Problem 2, p. 256Answers to Problem 2, p. 256

2a. Flow. GDP represents production per unit of time, such as a year or a quarter.b. Flow. National saving is measured per unit of time, analogous to individual

saving.c. Stock. This value is measured at a point in time.d. Stock. Again, the value is measured at a point in time.e. Flow. The deficit is the government’s spending less its receipts. Spending and

receipts are measured per unit of time, such as a year or quarter.f. Stock. The quantity of government debt outstanding is measured at a point in

time.

Why Do People Save?Why Do People Save?1. What does the phrase "keeping up with the Jones'" imply for saving rates?2. Why might people who lived through the Great Depression have a different propensity to

save than people who only remember the recent economic expansion?3. What effect is the retirement of "baby boomers" likely has on saving in the United States?

1. Demonstration effect will lower the saving rate.

2. They would have more need for precautionary saving. Also, they might be more frugal,hoping to save more for retirement because they don’t have the confidence of social security. They might also want to bequeath more to their children because they don’ttrust the future. (Precautionary Saving; Life-cycle Saving; Bequest Saving)

3. As more people retire compared to people in the work force, additions to savings will beless than withdrawals from savings resulting in a decrease in savings.

Life-Cycle SavingLife-Cycle SavingCollege fundMarriage planningExpecting babySaving for travelSaving for home

Why Do People Save?Why Do People Save? Payroll deductions for Christmas Clubs, retirement

pension funds might increase savings by eliminating the temptation to spend the available income.

Easy terms to borrow (high limits on credit cards, home equity loans) might increase the spending and reduce savings.

Higher real interest rates might convince people to save more.

Capital gains might reduce savings; capital losses might increase savings.

National SavingNational SavingY = C + I + G + NXAssume for now that NX=0.Y or GDP is also the incomes earned by

households (remember the circular flow?)Y = C + T + SC + T + S = C + I + G

National SavingNational Saving(T - G) + S = IGovernment Saving + Private Saving =

InvestmentInvestments (increasing the capital stock) is

financed by national saving.National Saving, therefore is the sum of

Public Saving and Private Saving.(T - G) + S = I = Y - C - G

Gross SavingGross Saving

http://www.bea.doc.gov/bea/dn/nipaweb/TableView.asp#Mid

Gross SavingGross SavingCapital consumption (depreciation) is keeping up

and repairing buildings and equipment. It is part of investment directly paid by savings.

Net foreign investment is the trade deficit which we will discuss later. For now, realize that Y=C+G+I+NX and Y=C+S+T would combine to give S+(T+G)=I+NX, i.e., trade balance shows up on the investment side in the previous slide.

Statistical discrepancy is to indicate that I=S but because data is collected from different sources it doesn’t match.

Savings RatesSavings RatesYears

Gross Saving

Personal Saving

Government Saving

Business Saving

1991 16.9% 6.18% -1.38% 12.10%

1992 15.9% 6.53% -2.48% 11.85%

1993 15.6% 5.27% -1.80% 12.14%

1994 16.3% 4.45% -0.61% 12.46%

1995 16.9% 4.06% -0.11% 12.95%

1996 17.2% 3.47% 0.75% 12.98%

1997 18.0% 3.03% 1.90% 13.07%

1998 18.8% 3.44% 3.11% 12.25%

1999 18.4% 1.73% 3.87% 12.79%

2000 18.1% 0.69% 4.69% 12.72%

2001 16.5% 2.00% 1.45% 13.05%

2002 14.1% 3.22% -0.65% 11.53%

2003 13.5% 2.76% -1.36% 12.10%

Savings Rates

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1990 1992 1994 1996 1998 2000 2002

% o

f GN

P

Gross Saving Personal Saving

Government Saving Business Saving

Low Household SavingsLow Household Savings By international standards, personal savings in the

US are low and getting even lower. Since it is national savings that matter for

investments, high business saving and increasing government saving eliminate the low personal saving.

Increase in wealth might be the reason for decreasing household saving.

Low savings and negative wealth for the poor households is a major concern.

The Size Distribution of Wealth (1983, 1989, 1992, 1995)Percentage Share of Net Worth or Financial Wealth Held by

Year Top 1% Next 4% Next 5% Next 10% Top 20% 2nd 20% 3rd 20% Bottom 40% Net Worth1983 33.8 22.3 12.1 13.1 81.3 12.6 5.2 0.91989 37.4 21.6 11.6 13.0 83.5 12.3 4.8 -0.71992 37.2 22.3 11.8 12.0 83.8 11.5 4.4 0.41995 38.5 21.8 11.3 12.1 83.9 11.4 4.5 0.2

Financial Wealth1983 42.9 25.1 12.3 11.0 91.3 7.9 1.7 -0.91989 46.9 23.9 11.6 10.9 93.4 7.4 1.7 -2.41992 45.6 25.0 11.3 10.2 92.3 7.3 1.5 -1.11995 47.2 24.6 11.2 10.1 93.0 6.9 1.4 -1.3

Source: Wolff, E., "Recent Trends in the Size Distribution of Household Wealth," Journal of Economic Perspectives , Summer 1998, 12:3, 131-150

http://www.levy.org/modules/pubslib/files/wp407.pdf

http://www.levy.org/default.asp?view=publications_view&pubID=fc9864a2ee

http://www.inequality.org/facts.html

http://www.inequality.org/facts.html

http://www.inequality.org/facts.html

Investment and Capital Investment and Capital FormationFormation

The importance of national saving is that it finances investment.

Investment is capital formation.Capital formation increases the physical

capital in a country, raising average labor productivity.

Factors That Affect InvestmentFactors That Affect InvestmentPrice of capital goods: lower price, more

investment.Real interest rate: lower real interest rate,

more investment.Technological advancement that increases

the marginal product of capital.Lower taxes on the revenues generated by

capital.A higher relative price for the firm’s output.

Problem 7, p. 257Problem 7, p. 257Ellie and Vince are trying to decide whether to purchase a new home. The house they want is priced at $200,000. Annual expenses such as maintenance, taxes, and insurance equal 4% of the home’s value. If properly maintained, the house’s real value is not expected to change.The real interest rate is 6%. They pay no down-payment and ignore mortgage tax-deduction.(a) If they are willing to pay $1500 monthly rent for a similar house, should they buy the

house?(b) What if they were willing to pay $2000?(c) What if the real interest rate were 4%?(d) What if the price of the house were $150,000?(e) Why do home-building companies dislike high interest rates?

(a) No.(b) Yes.(c) Yes.(d) Yes.

Savings and InvestmentsSavings and Investments People save to accumulate

wealth. People save for life-cycle

reasons. People save for

precautionary reasons. People save for

bequeathing. People save in response to

high real interest rates.

People invest when the price of capital goods fall.

When the marginal product of capital increases due to technology.

When the relative price of the output rises.

When taxes on revenue generated are lowered.

When real interest rates are low.

Financial MarketsFinancial MarketsReal interest rate

Saving and investment

S

I

Savings are funds to be lent. Savers are also lenders. Investorsare borrowers. Ceteris paribus, they both respond to real interestrates.What happens when r is not at equilibrium?

ShiftsShifts What happens when stock market falls? What happens when war breaks out? What happens when a new child is born to the family? What happens when the government budget moves

from surplus to deficit? What happens when new legislation is passed that

increases Social Security payments in the future? What happens when “baby boom” generation reaches

working age? What happens when “baby boom” generation reaches

retirement?

ShiftsShiftsWhat happens when price of computing

power drops by 50%?What happens a new software increases the

output of a computer?What happens when the designs created by

using a computer/software are much in demand – higher in price?

What happens when the government puts an extra tax on mobile phones?