Chapter 18

Saving, Capital Formation,

and Financial Markets
“A country with no savings cannot invest in it’s future”

1
©2012 The McGraw-Hill Companies, All Rights Reserved
 Learning Objectives

1. Explain the relationship between savings and wealth

2. Learn how to derive national savings in a closed economy
3. Recognize and work with the components of national
savings
4. Discuss the reasons firms choose to invest in capital
rather than financial assets
5. Analyze the financial market using supply and demand
6. Learn how the determinants of supply and demand affect
equilibrium in the financial market
7. Understand and explain the functioning of fiscal policy
using the financial market framework
2
©2012 The McGraw-Hill Companies, All Rights Reserved
 Savings and Wealth

 Saving is current income minus spending

 Saving rate is saving divided by income
 Wealth is the value of assets minus
liabilities
 Assets are the valuables that one owns
 Liabilities are the debts one owes
 Balance sheet is a list of assets and liabilities

3
©2012 The McGraw-Hill Companies, All Rights Reserved
 Maria’s Balance Sheet, 1/1/2015

Assets Liabilities
Cash $80 Student loan $3,000
Checking account 1,200 Credit card balance 250
Shares of stock 1,000
Car (market value) 3,500
Furniture (market value) 500
Total $6,280 $3,250
Net worth $3,030

4
©2012 The McGraw-Hill Companies, All Rights Reserved
 Stock Variables vs Flow Variables

 A stock variable is defined at a point in time

 Wealth ■ Debt
 A flow variables is defined per unit of time
 Income ■ Spending
 Saving ■ Wages
 Other things equal, the flow of saving causes the
stock of wealth to change
 Every dirham a person saves adds to his/her wealth
 A high rate of saving today leads to an improved
standard of living in the future if the real interest or real
return earned is on average positive over time.
5
©2012 The McGraw-Hill Companies, All Rights Reserved
 Capital Gains and Losses

 Wealth changes when the value of your assets

change
 Capital gains increase the value of existing
assets
 Higher value for the land you bought earlier
 Capital losses decreases the value of existing
assets
 Car accident decreases the value of your vehicle

Change in wealth =
Saving + Capital gains – Capital losses
6
©2012 The McGraw-Hill Companies, All Rights Reserved
 National Saving and Its Components

 Macroeconomists are interested primarily in saving and wealth for

the country as a whole.
 National saving includes the saving of business firms, the
government, and households. Households provide the largest share
of savings in the economy.
Y = C + I + G + NX
= aggregate income
= consumption expenditure = government purchases of
goods and services
= investment spending = net exports

7
©2012 The McGraw-Hill Companies, All Rights Reserved
 Calculate National Savings

 For simplicity, assume a closed economy

 National savings (S) is current income less spending
 Current income is GDP or Y
 Spending
 Excludes all private investment spending (I)
 Includes consumption and government spending
 Thus,

Y=C+I+G
Y–C–G=I
S=I

8
©2012 The McGraw-Hill Companies, All Rights Reserved
 Private Saving

 Private saving is after-tax income less

consumption
SPRIVATE = Y – T – C
 Private saving is generated primarily by
households and firms although households
pay a more prominent role.

9
©2012 The McGraw-Hill Companies, All Rights Reserved
 Public Saving and National Saving

 Public saving is the amount of the public sector's (the

government) income that is not spent
 Public sector income comes from taxes
 Public sector spending is G

SPUBLIC = T – G

 National saving (S) is private savings plus public

savings
SPRIVATE + SPUBLIC = (Y – T – C) + (T – G)
S=Y–C–G
10
©2012 The McGraw-Hill Companies, All Rights Reserved
 Why Do People Save?

1. Life-cycle saving is to meet long-term

objectives
 Retirement Purchase a home ■

 Children's college education

2. Precautionary saving is for protection

against setbacks
 Loss of job ■ Medical emergency
3. Bequest saving is to leave an inheritance
 Mainly higher income groups
11
©2012 The McGraw-Hill Companies, All Rights Reserved
 Capital Formation (Investment)

 Investment is the creation of new capital goods

and housing
 Firms buy new capital to increase profits via
changes in productivity, both labor and capital.
 Investment creates jobs in the economy
 Capital and financial investment differ in the
sense that capital investments generate an
active rate of return while financial investment
generate a passive rate of return.
12
©2012 The McGraw-Hill Companies, All Rights Reserved
 The Investment Decision

 Two important costs:

 Price of the capital goods
 Real interest rates or cost of funds
 opportunity cost of the investment
 The value of the marginal product of
capital is also known as return on
investment

13
©2012 The McGraw-Hill Companies, All Rights Reserved
 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 increases.
Upward sloping representing the higher
opportunity cost of holding cash.
 Demand for investment (I), is the amount of
savings borrowed at each possible real interest rate
 The quantity demanded is inversely related to the
interest rate, r. Downward sloping representing
higher investment opportunities.

14
©2012 The McGraw-Hill Companies, All Rights Reserved
 Financial Market

 Equilibrium interest rate

Saving S
equates the amount of

Real interest rate (%)

savings with the amount
of investments
 If r is above
r
equilibrium, there is a
surplus of savings Investment I
 If r is below
equilibrium, there is a S, I
shortage of savings Saving and investment
15
©2012 The McGraw-Hill Companies, All Rights Reserved
 Financial Markets Are Markets

 In a free-market economy, financial markets

adjust to surpluses and shortages as any
other market does
 Equilibrium Principle holds
 Changes in determinants will shift the
savings or investment curves
 New equilibrium

16
©2012 The McGraw-Hill Companies, All Rights Reserved
 Determinants of Savings
 Government Budget (T – G)
 Taxes on interest earned or on interest income. Taxes on
interest earned or interest income affect savings via lower
payout
 Credibility of the Financial System
 Taxes on interest earned and credibility in the financial
system, affects the level of savings via the incentive
principle. A higher incentive to save (lower taxes on
interest income or a more solid and credible financial
system), leads to higher savings, implying lower
consumption (C). Thus, other things equal, private
savings increase.
17
©2012 The McGraw-Hill Companies, All Rights Reserved
 The Government Budget

 Balanced budget occurs when government

spending equals net tax receipts (or
government revenue)
 Government budget surplus is the excess of
government net tax receipts over spending (T –
G > 0)
 Budget surplus is public savings
 Government budget deficit is the excess of
government spending over net tax receipts
 Budget deficit is public dissaving (T – G < 0)
18
©2012 The McGraw-Hill Companies, All Rights Reserved
 Government Budget Deficit Increases

S'  Other things equal, as the

S
government budget deficit
Real interest rate (%)

increases:
F
 Reduces national saving
r' E
 Movement up the
r
investment curve
I
 Higher interest rate
 Lower level of savings
and investment
A' A
Saving and investment  Private investment is
crowded out

19
©2012 The McGraw-Hill Companies, All Rights Reserved
Taxes on Interest Income (or Interest earned)

 Why would the supply of savings shift?

 By taxing savings less heavily, households would
increase their savings by consuming a smaller
fraction of their income because a reduction in
taxes on savings means a net increase in the
payoff of savings. The additional savings increase
their deposits in banks thus the supply of savings
shift to the right.
 What happens if the tax on interest income
increases?
20
©2012 The McGraw-Hill Companies, All Rights Reserved
 Credibility of the
Financial System
 People’s confidence in the financial system
is important. When people loose confidence
in the financial system they withdraw their
savings affecting the total level of savings
in the economy.

 What happens to the supply of savings

when the public loses (or gain) confidence
in the financial system?
21
©2012 The McGraw-Hill Companies, All Rights Reserved
 Determinants of Investment

 Technological Improvement (increases

expected return on investment via higher
marginal productivity of capital and labor)
 Fiscal Policy

22
©2012 The McGraw-Hill Companies, All Rights Reserved
 Technological Improvement

 Other things equal, new

S
technology raises
marginal productivity of
Real interest rate (%)

capital:
F
r'  Increases the demand for
E
r investment funds
I'  Movement up the
I savings supply curve
 Higher interest rate

A A'  Higher level of savings

Saving and Investment and investment

23
©2012 The McGraw-Hill Companies, All Rights Reserved
 Fiscal Policy

 Fiscal Policy: Government policy dealing with taxes and

government spending.
 Fiscal Policy is commonly used, though less commonly
used than Monetary Policy, during periods of economic
turbulence (recession and overheating). The two most
common tools of fiscal policy are:
 Investment tax credits
 Investment subsidies

24
©2012 The McGraw-Hill Companies, All Rights Reserved
 Fiscal Policy and Financial Market:
How Fiscal Policy Affects Financial Markets?

 Other things equal, if investment tax credits and/or

investment subsidies increase, investment shifts to the
right (implemented to prevent a recessionary economy).
 Other things equal, if investment tax credits and/or
investment subsidies decrease, investment shifts to the
left (implemented to slow down the economy and
prevent it economy from overheating).

25
©2012 The McGraw-Hill Companies, All Rights Reserved
 Increase in Investment Tax Credits (or
Investment Subsidies)

 An increase in investment
S
tax credit or investment
subsidy:
Real interest rate (%)

 Increases the demand for

F
r' investment funds
E
r  Movement up the
I' savings supply curve
I  Higher interest rate

 Higher level of savings

A A' and investment
Saving and Investment

26
©2012 The McGraw-Hill Companies, All Rights Reserved