Saving, Capital Formation, and Financial Markets - PowerPoint Presentation

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Saving, Capital Formation, and Financial Markets

Chapter 19

McGraw-Hill/Irwin

Copyright ©

2015

by

McGraw-Hill Education (Asia).

All rights reserved.

Slide2

Learning Objectives

Explain the relationship between savings and wealthIdentify and apply the components of national savingDiscuss the reasons why people saveDiscuss the reasons why firms choose to invest in capital rather than financial assetsAnalyze financial markets using the tools of supply and demand

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Savings and Wealth

Saving is current income minus spending on current needsThe saving rate is saving divided by incomeWealth is the value of assets minus liabilitiesAssets are anything of value that one ownsLiabilities are the debts one owesThe balance sheet is a list of an economic unit’s assets and liabilitiesSpecific dateEconomic unit (business, household, etc.)

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Individual Balance Sheet, 1/1/14

AssetsLiabilities

Cash

$80

Student loan

$3,000

Checking account

1,200

Credit card balance

250

Shares of stock

1,000

Car (market value)

3,500Furniture (market value) 500Total $6,280 $3,250Net worth $3,030

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Flow Values and Stock Values

A flow value is defined per unit of timeIncome ■ SpendingSaving ■ WageA stock value is defined at a point in timeWealth ■ DebtThe flow of savings causes the stock of wealth to changeEvery dollar a person saves adds to his wealthA high rate of saving today leads to an improved standard of living in the future

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Capital Gains and Losses

Wealth changes when the value of your assets changeCapital gains increase the value of existing assetsHigher value for stockCapital losses decreases the value of existing assetsCar accident damages bumper and front headlightChange in wealth = Saving + Capital gains – Capital losses

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US Stock Prices, 1960 - 2004

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The Bull Market of the 1990s

Stock ownership increasedDirect purchasesMutual fundsPension and retirement fundsStock prices rose rapidlyCapital gains on stocks increased household wealthMay have decreased household savingsStock market declined, 2000 – 2002Household savings remained lowValue of privately-owned homes increased rapidly

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National Savings

Macroeconomics studies total savings in the economyHousehold savings is one componentBusiness and government savings are other partsStart with the definition of production and income for the economyY = C + I + G + NXY = aggregate income

C = consumption expenditure

G = government purchases of goods and services

I = investment spending

NX = net exports

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Calculate National Savings

Assume NX = 0 for simplicityNational savings (S) is current income less spending on current needsCurrent income is GDP or YSpending on current needs Exclude all investment spending (I)Most consumption and government spending is for current needsFor simplicity, we assume all of C and all of G are for current needsS = Y – C – G

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National Savings, 1960 - 2011

Since 1960, US national savings rate has been 11–21% whereas Singapore has much higher rateLess volatile than household savings

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Private Saving

Private saving is household plus business savingHousehold's total income is YHouseholds pay taxes (T) from this incomeGovernment transfer payments increase household incomeTransfer payments are made by the government to households without receiving any goods in returnInterest is paid to government bond holdersT = Taxes – Transfers – Government interest payments

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Private Saving

Private saving is after-tax income less consumptionSPRIVATE = Y – T – CPrivate saving is done by households and businessesHousehold saving or personal saving is done by families and individualsBusiness savings makes up the majority of private saving in the USBusiness savings is revenues less operating costs less dividends to shareholdersBusiness savings can purchase new capital equipment

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Public Saving and National Saving

Public saving is the amount of the public sector's income that is not spend on current needsPublic sector income is net taxesPublic sector spending on current needs is GSPUBLIC = T – GNational saving (S) is private savings plus public savingsSPRIVATE + SPUBLIC = (Y – T – C) + (T – G)

S = Y – C – G

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The Government Budget

Balanced budget occurs when government spending equals net tax receiptsGovernment budget surplus is the excess of government net tax collections over spending (T – G)Budget surplus is public savingsGovernment budget deficit is the excess of government spending over net tax collectionsBudget deficit is public dissavings

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Government Saving

Federal Government (billions of dollars) 2000

Receipts

$2,057.1

Expenditures

1,871.9

State and Local Governments

Receipts

1,322.6

Expenditures

1,281.3

Federal Government (billions of dollars)

2010

Receipts $2,385.2Expenditures 3,718.7State and Local GovernmentsReceipts 2,128.1Expenditures 2,095.2

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From Surplus to Deficit

Three reasons for change in U.S. government budgetGovernment receipts decreased during the recessions of 2001 and 2007-2009 Lower income during recession means lower taxesTax reductions during the first Bush termGovernment spending increasedWars in Iraq and AfghanistanHomeland Security

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U.S.

National Saving, 1960-2010

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Low Household Savings

National savings determines a country's ability to invest in new capital goodsHousehold savings has been lowBusiness saving has been significantIn the 1990s, government saving increasedFrom 1960 to 2002, U.S. national saving rate was fairly stableSince 2002, U.S. government dissaving has contributed to a decline in the U.S. national saving rate

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Three Reasons for Household Saving

Life-cycle saving is to meet long-term objectivesRetirement ■ Purchase a homeChildren's college attendancePrecautionary saving is for protection against setbacksLoss of job ■ Medical emergencyBequest saving is to leave an inheritanceMainly higher income groups

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Household Saving in Japan

After World War II, household saving rates were 15 – 25%Declined after 1990Life-cycle motives are importantLong life expectancyRetire relatively early; long retirement periodAge structure of the population favored savingHousing prices and down payment requirements were very highProperty values decreased after 1990Bequest savings matters; precautionary savings is low

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Saving and the

Real Interest RateSavings often take the form of financial assets that pay a returnInterest-bearing checking ■ BondsSavings ■ CDsMutual funds ■ StocksThe real interest rate (r) is the nominal interest rate (i) minus the rate of inflation ()The increase in purchasing power from a financial assetMarginal benefit of the extra saving

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Thrifts and Spends

Two otherwise identical families have different savings ratesHigher savings reduces current consumptionThrifts consume $32,000 in 1980 and Spends consume $38,000Thrifts get more unearned incomeThrift's income grows fasterFrom 1995 on, Thriftsconsume more than Spends

Spends

Thrifts

Savings Rage

5%

20%

Start Date

1980

1980

End Date

2015

2015

Real Income$40,000$40,000Real Interest8%8%

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Thrifts and Spends

By 2015Spend’s consumption is $12,000 more than Thrift'sRetirement savings is $385,000Spend's accumulated savings is $77,000

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Savings in Perspective

8% is lower than the return to mutual funds since 198020% savings is higher than typical householdMany have $5,000+ in credit card debt at high interest ratesBottom line: High savings rate pays off in the long runIf people are target savers, a high interest rate lowers savings rateTo get $25,000 in five years,Save $4,309 per year at 5% ORSave $3,723 per year at 10%Data show higher real rates increase savings modestly

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Maximize Lifetime Well Being

Psychologists suggest individual self-control may be too weak to produce rational outcomesSmoking, obesity, gambling, and spendingDevices to support savingsMake savings automatic and withdrawals costlyPenalties for early withdrawal of IRA fundsEasy borrowing supports high levels of current spendingCredit cardsHome equity loans

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Explaining U.S. Household Savings Rate

Savings rate may be depressed by Social Security, Medicare, and other government programs for the elderlyMortgages with small or no down paymentConfidence in a prosperous futureIncreasing value of stocks and growing home valuesReadily available home equity loansDemonstration effects and status goods

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Investment and Capital Formation

Investment is the creation of new capital goods and housingFirms buy new capital to increase profitsCost – Benefit PrincipleCost is the cost of using the machine or other capitalBenefit is the value of the marginal product of the capital

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Larry and the Lawn Mower

Larry's lawn care business planCost of lawn mower = $4,000Interest on loan = 6%Assume the mower can be resold for $4,000Net revenue = $6,000 per summerTaxes = 20%Larry could earn $4,400 per summer after tax working elsewhereCost – Benefit Principle indicates whether Larry should start the business

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Larry and the Lawn Mower

Business plan analysisNet revenue $6,000Less taxes (20%) $1,200Less opportunity cost $4,400Equals VMP of lawnmower $400Less interest (6%) $240Equals net benefit $160Larry should start the business

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The Investment Decision

Two important costsPrice of the capital goodsReal interest ratesOpportunity cost of the investmentValue of the marginal product of the capital is its benefitNet of operating and maintenance expenses and of taxes on revenues generatedTechnical innovation increases benefitsLower taxes increase benefitsHigher price of the output increases benefits

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Investment in Computers

Purchases of new computers and software is more than 2.5% of GDP24% of all private nonresidential investmentComputer investment increased faster than other capital goodsUnique attributes of computers are The declining price of computing powerComputing power per dollar doubles every 18 monthsThe increase in the value of the marginal product of computers

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Investment in Computers, 1960-2010

Computer technology may have driven increases in productivity since 1995

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Saving, Investment, and Financial Markets

Supply of savings (S) is the amount of savings that would occur at each possible real interest rate (r)The quantity supplied increases as r increasesDemand for investment (I) is the amount of savings borrowed at each possible real interest rateThe quantity demanded is inversely related to r

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Financial Market

Equilibrium interest rate equates the amount of saving with the investment funds demandedIf r is above equilibrium, there is a surplus of savingsIf r is below equilibrium, there is a shortage of savings

Saving and investment

Real interest rate (%)

Investment I

Saving S

S, I

r

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Financial Markets Are Markets

Financial markets adjust to surpluses and shortages as any other market doesEquilibrium Principle holdsChanges in factors other than real interest rates will shift the savings or investment curvesNew equilibrium

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Technological Improvement

New technology raises marginal productivity of capitalIncreases the demand for investment fundsMovement up the savings supply curveHigher interest rateHigher level of savings and investmentSaving and Investment

Real interest rate (%)

I

r

E

S

r'

I'

F

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Government Budget Deficit Increases

Government budget deficit increasesReduces national savingMovement up the investment curveHigher interest rateLower level of savings and investmentPrivate investment is crowded out

I

Saving and investment

Real interest rate (%)

S

r

E

r'

F

S'

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Increase National Saving

Policymakers know the benefits of increased national saving ratesReducing government budget deficit would increase national savingPolitical problems Increase incentives for householdsConsumption taxReduce taxes on dividends and investment incomeHigher national saving rate leads to greater investment in new capital goods and a higher standard of living

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Saving, Capital Formation, and Financial Markets

SavingWealthCapital Gains and Losses

National

Private Saving

Public Saving

Government Budget

Low Household Saving

Interest Rate

Investment and Capital

Financial Markets