11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 9: Saving and Ch. 9: Saving and Capital FormationCapital Formation

22

IntroductionIntroduction

Motives for SavingMotives for SavingTo meet future expendituresTo meet future expendituresProtect against an economic emergencyProtect against an economic emergencyProduce capital goodsProduce capital goods

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

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

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

What is her saving?What is her saving?

44

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

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

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

between assets one owns minus liabilities between assets one owns minus liabilities one owes.one owes.

Why would Joan’s $150 in savings Why would Joan’s $150 in savings increase her wealth?increase her wealth?

55

Net WorthNet Worth

For Joan, her net worth is the difference For Joan, her net worth is the difference between her assets and her liabilities.between her assets and her liabilities.

Her net worth is a combination of both Her net worth is a combination of both real and financial assets.real and financial assets.

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

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Savings and WealthSavings and Wealth

Capital GainsCapital Gains Increases in the value of existing assetsIncreases in the value of existing assets

Capital LossesCapital LossesDecreases in the value of existing assetsDecreases in the value of existing assets

77

The Bull Market of the 1990sThe Bull Market of the 1990s

Observations• During the 1990s, household saving fell while wealth rose• Households acquired stocks in the 1990s and stock prices rose• 2000 - 2001 the fall in stock prices was offset by rising home values

http://realstockprices.com/node/1

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Saving At the National LevelSaving At the National Level

The portion of income not spent on The portion of income not spent on consumption but spent on acquiring consumption but spent on acquiring wealth by households, firms and wealth by households, firms and governments will constitute the national governments will constitute the national saving.saving.

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

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Household Saving Rate in the Household Saving Rate in the United States, 1960 - 2001United States, 1960 - 2001

Observations•Household saving has fallen dramatically•National saving has not declined in recent years

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=120&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=2006&LastYear=2007&3Place=N&Update=Update&JavaBox=no#Mid

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What Is Capital Formation?What Is Capital Formation?

Net additions to the stock of capital is Net additions to the stock of capital is capital formation.capital formation.

At the household level, additions to net At the household level, additions to net worth (savings) is “capital formation.”worth (savings) is “capital formation.”

At the national level, all the assets At the national level, all the assets minus liabilities will constitute net worth minus liabilities will constitute net worth and additions to assets or reductions and additions to assets or reductions from liabilities will increase net worth.from liabilities will increase net worth.

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

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

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

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

Savings are primarily financial (except Savings are primarily financial (except homes).homes).

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

stocks and bonds which you use for down stocks and bonds which you use for down payment.payment.

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

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

you bought the house, what is it now?you bought the house, what is it now?

1313

Home ExampleHome Example

The Bank had no assets and 85 people The Bank had no assets and 85 people deposited $1000 each - liabilities of $85K deposited $1000 each - liabilities of $85K and cash (assets) of $85K.and cash (assets) of $85K.

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

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

bought the new house.bought the new house.

1414

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

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

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

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

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

1515

Savings and InvestmentSavings and Investment

The importance of saving and The importance of saving and investment is the ability to convert the investment is the ability to convert the financial wealth into capital stock.financial wealth into capital stock.

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

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

1616

Answers to Problem 1, p. 266Answers to Problem 1, p. 2661a. 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.

1717

Answers to Problem 2, p. 267Answers to Problem 2, p. 267

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.

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Real Interest RatesReal Interest Rates

Real interest rates will play a pivotal role Real interest rates will play a pivotal role in affecting the decisions of 85 savers, in affecting the decisions of 85 savers, your readiness to borrow the $85,000 your readiness to borrow the $85,000 and the bank’s willingness to lend the and the bank’s willingness to lend the money.money.

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

1919

Why Do People Save?Why Do People Save?

Life-Cycle SavingLife-Cycle SavingSaving to meet long-term objectives, such as Saving to meet long-term objectives, such as

retirement, college attendance, or the retirement, college attendance, or the purchase of a homepurchase of a home

2020

Why Do People Save?Why Do People Save?

Precautionary SavingPrecautionary SavingSaving for protection against unexpected Saving for protection against unexpected

setbacks, such as the loss of a job or a setbacks, such as the loss of a job or a medical emergencymedical emergency

2121

Why Do People Save?Why Do People Save?

Bequest SavingBequest SavingSaving done for the purpose of leaving an Saving done for the purpose of leaving an

inheritanceinheritance

2222

Why Do People Save?Why Do People Save?

ObservationObservation If people are If people are targettarget savers, a high real interest savers, a high real interest

rate may reduce saving.rate may reduce saving.

2323

Why Do People Save?Why Do People Save?

Payroll deductions for Christmas Clubs, Payroll deductions for Christmas Clubs, retirement pension funds might increase savings retirement pension funds might increase savings by eliminating the temptation to spend the by eliminating the temptation to spend the available income.available income.

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

Higher real interest rates might convince people Higher real interest rates might convince people to save more.to save more.

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

2424

Self-Control HypothesisSelf-Control Hypothesis

George Lowenstein, Brian Knutson, Drazen George Lowenstein, Brian Knutson, Drazen Prelec (Prelec (NeuronNeuron, 2007), 2007) People lack the self-control to savePeople lack the self-control to save Techniques to offset the lack of self-control and Techniques to offset the lack of self-control and

increase savingsincrease savings Payroll savingsPayroll savings Retirement accounts with limited withdrawalsRetirement accounts with limited withdrawals

Factors that may reduce self-control and savingsFactors that may reduce self-control and savings Home equity loansHome equity loans Credit cards with high borrowing limitsCredit cards with high borrowing limits

2525

Why Do People Save?Why Do People Save?

Demonstration effectsDemonstration effectsPeople use spending by others to measure the People use spending by others to measure the

adequacy of their own spending.adequacy of their own spending.When satisfaction depends on relative living When satisfaction depends on relative living

standards, an upward spiral of spending can standards, an upward spiral of spending can occur, which reduces savings.occur, which reduces savings.

2626

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.

2727

Why do Japanese households Why do Japanese households save so much?save so much?

Life-cycle motiveLife-cycle motive Long life expectancyLong life expectancy Retire relatively earlyRetire relatively early Housing prices are very high and down payment Housing prices are very high and down payment

requirements are also highrequirements are also high Bequest motiveBequest motive

Parents, who live with their children after retirement, Parents, who live with their children after retirement, leave a large inheritanceleave a large inheritance

Precautionary motivePrecautionary motive Very high job security reduces the precautionary Very high job security reduces the precautionary

motivemotive

2828

Why do U.S. households Why do U.S. households save so little?save so little?

Life-cycle motiveLife-cycle motive Social security and MedicareSocial security and Medicare Low down payment requirements for home mortgagesLow down payment requirements for home mortgages

Precautionary motivePrecautionary motive Stable economic performanceStable economic performance Strong capital gainsStrong capital gains

Self-control effectSelf-control effect U.S. financial markets may have made it “too” easy to U.S. financial markets may have made it “too” easy to

borrowborrow Demonstration effectDemonstration effect

Increased real wage inequalityIncreased real wage inequality

2929

http://www.economist.com/finance/displaystory.cfm?story_id=13240636

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

households (remember the circular households (remember the circular flow?)flow?)

Y = C + T + SY = C + T + SC + T + S = C + I + GC + T + S = C + I + G

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

InvestmentInvestment Investments (increasing the capital Investments (increasing the capital

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

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

3232

U.S. National SavingU.S. National SavingRate, 1960 - 2001Rate, 1960 - 2001

3333

Gross SavingGross Saving

http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=5&FirstYear=2005&LastYear=2006&Freq=Qtr

3434

Savings RatesSavings Rates

YearsYearsGross Gross SavingSaving

Personal Personal SavingSaving

Government Government SavingSaving

Business Business SavingSaving

19911991 16.9%16.9% 6.18%6.18% -1.38%-1.38% 12.10%12.10%

19921992 15.9%15.9% 6.53%6.53% -2.48%-2.48% 11.85%11.85%

19931993 15.6%15.6% 5.27%5.27% -1.80%-1.80% 12.14%12.14%

19941994 16.3%16.3% 4.45%4.45% -0.61%-0.61% 12.46%12.46%

19951995 16.9%16.9% 4.06%4.06% -0.11%-0.11% 12.95%12.95%

19961996 17.2%17.2% 3.47%3.47% 0.75%0.75% 12.98%12.98%

19971997 18.0%18.0% 3.03%3.03% 1.90%1.90% 13.07%13.07%

19981998 18.8%18.8% 3.44%3.44% 3.11%3.11% 12.25%12.25%

19991999 18.4%18.4% 1.73%1.73% 3.87%3.87% 12.79%12.79%

20002000 18.1%18.1% 0.69%0.69% 4.69%4.69% 12.72%12.72%

20012001 16.5%16.5% 2.00%2.00% 1.45%1.45% 13.05%13.05%

20022002 14.1%14.1% 3.22%3.22% -0.65%-0.65% 11.53%11.53%

20032003 13.5%13.5% 2.76%2.76% -1.36%-1.36% 12.10%12.10%

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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

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Low Household SavingsLow Household Savings

By international standards, personal savings By international standards, personal savings in the US are low and getting even lower.in the US are low and getting even lower.

Since it is national savings that matter for Since it is national savings that matter for investments, high business saving and investments, high business saving and increasing government saving eliminate the increasing government saving eliminate the low personal saving.low personal saving.

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

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

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Investment and Capital Investment and Capital FormationFormation

The importance of national saving is that it The importance of national saving is that it finances investment.finances investment.

Investment is capital formation.Investment is capital formation.Capital formation increases the physical Capital formation increases the physical

capital in a country, raising average labor capital in a country, raising average labor productivity.productivity.

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

investment.investment. Real interest rate: lower real interest rate, Real interest rate: lower real interest rate,

more investment.more investment. Technological advancement that increases Technological advancement that increases

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

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

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Investment in Computers Investment in Computers and Software, 1960 - 2001and Software, 1960 - 2001

4040

Problem 7, p. 257Problem 7, p. 257

Ellie 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.

4141

Savings and InvestmentsSavings and Investments

People save to People save to accumulate wealth.accumulate wealth.

People save for life-cycle People save for life-cycle reasons.reasons.

People save for People save for precautionary reasons.precautionary reasons.

People save for People save for bequeathing.bequeathing.

People save in response People save in response to high real interest to high real interest rates.rates.

People invest when the People invest when the price of capital goods fall.price of capital goods fall.

When the marginal When the marginal product of capital product of capital increases due to increases due to technology.technology.

When the relative price of When the relative price of the output rises.the output rises.

When taxes on revenue When taxes on revenue generated are lowered.generated are lowered.

When real interest rates When real interest rates are low.are low.

4242

Financial MarketsFinancial Markets

Real 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?

4343

The Effect of a New Technology The Effect of a New Technology on National Saving and Investmenton National Saving and Investment

Saving and investment

Rea

l in

tere

st r

ate

(%)

I

rE

S

I’

r’F

New Technology• Raises the marginal

productivity of capital• This increases the

demand for capital

4444

Increase in the Government Budget DeficitIncrease in the Government Budget Deficit

Saving and investment

Rea

l in

tere

st r

ate

(%)

S

I

r

Er’

F

S’

Increases in the government budget deficit:•Reduces S public and national saving•r will increase•S & I will fall

4545

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

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

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

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

retirement?retirement?

4646

ShiftsShifts

What happens when price of computing What happens when price of computing power drops by 50%?power drops by 50%?

What happens a new software What happens a new software increases the output of a computer?increases the output of a computer?

What happens when the designs What happens when the designs created by using a computer/software created by using a computer/software are much in demand – higher in price?are much in demand – higher in price?

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

4747

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

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

4949

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

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

5151

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

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

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5454

5555

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