Chapter 8 Saving Capital Formation and Financial Markets o Investment and the Financial System o If the key driver of economic growth is investment the markets and sectors producing investment must be understood o All players in society can be positively adversely effected by the financial sector o Savings and Wealth o Saving current income minus spending on current needs The saving rate is saving divided by income o Wealth the value of assets minus liabilities Assets are anything of value that one owns The balance sheet is a list of an economic unit s assets and Liabilities are the debts one owes liabilities Specific date Economic unit business household etc o Flow Values and Stock Values o A flow value is defined per unit of time Income spending Saving Wage Wealth Debt o A stock value id defined at a point in time o The flow of savings causes the stock of wealth to change Every dollar a person saves adds to his wealth o A high relate of saving today leads to an improved stand of living in the future o Capital Gains and Losses o Wealth changes when the value of your assets change Capital gains increase the value of existing assets Higher value for stock Capital losses decreases the value of existing assets Car accident damages bumper and front headlight o Change in wealth savings Capital gains capital losses o Saving Investment and the Financial System o Financial system the system of financial markets and financial intermediaries through which firms acquire funds from households o An overview of the financial system Financial markets markets where financial securities such as stock and bonds are bought and sold Financial intermediaries firms such as banks mutual funds pension funds and insurance companies that borrow funds from savers and lend them to borrowers o The Macroeconomics of Saving and Investment Y C I G NX Y C I G I Y C G Sprivate Y TR C T SPublic T G TR S SPrivate Spublic So we can conclude that total savings must equal total Investment S I o National Savings o Macroeconomics studies total savings in the economy Household savings is one component Business and government savings are other parts o Start with the definition of production and income for the economy Y C I G NX Y Aggregate income C consumption expenditure G government purchases of goods and services NX net exports I Investment spending o Calculate National Savings o Assume NX 0 for simplicity o National savings S is current income less spending on current needs Current income is GDP or Y o Spending on current needs o Private Saving Exclude all investment spending I Most consumption and government spending is for current needs We assume all of c and g are for current needs S Y C G o Private saving is house hold plus business saving o Households pay taxes T from this income Government transfer payments increase household income Transfer payments are made by the government to households with receiving any goods in return Interest is paid to government bond holders T Taxes Transfers government interest payment o Private saving is after tax income less consumption Sprivate Y T C o Private saving is done by households and businesses Household saving or personal saving is done by families Business savings makes up the majority of private saving and individuals in the US Business savings is revenues less operating costs less dividends to shareholders Business savings can purchase new capital equipment o Explaining U S Household Savings Rate o Savings rate may be depressed by Social security Medicare and other government programs from the elderly Mortgages with small or no down payment Confidence in a prosperous future Readily available home equity loans Demonstration effects and status goods Increasing value of stock and growing home values o Public Saving and National Saving o Public saving is the amount of the publi sector s income that is not spent on current needs Public sector income is net taxes Public sector spending on current needs is G Spublic T G o National Saving S is private savings plus public savings Sprivate Spublic Y T C T G o The Government Budget o Balanced budget occurs when government spending equals net tax receipts Government budget surplus is the excess of government net tax collections over spending T G Budget surplus is public savings Government budget deficit is the excess of government spending over net tax collections Budget deficit is public dissavings o Saving and the Real Interest Rate o Savings often take the form of financial assets that pay a return Interest bearing checking bonds Savings CDs Mutual funds Stocks o The Real interest rate is the nominal interest rate i minus the rate of inflation pie The increase in purchasing power from a financial asset Marginal benefit of the extra saving o Investment and Capital Formation Investment is the creation of new capital goods and housing o o Firms buy new capital to increase profits Cost benefit principle Cost is the cost of using the machine or other capital Benefit is the value of the marginal product of the capital o Investment Decision o Two Important costs Price of the capital goods Real interest rates Opportunity cost of the investment o Value of the marginal product of the capital is its benefit Net of operating and maintenance expenses and of taxes on revenues generated Technical innovation increases benefits lower taxes increase benefits Higher price of the output increases benefits o Saving Investment and Financial Markets o The market for loanable funds The interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged Demand and supply in the loanable funds market An increase in the demand for loanable funds Crowding Our a decline in private expenditures as a result of an increase in government purchases The effect of a budget deficit on the market for loanable funds o Supply of savings s is the amount of savings that would occur at each possible real interest rate The quantity supplied increase as r increases o Demand for investment I is the amount of savings borrowed at each possible real interest rate The quantity demanded is inversely related to r o Financial Markets are Markets o Financial markets adjust to surpluses and shortages as any o Changes in factors other than real interest rates will shift the other market does Equilibrium principle holds savings or investment curves New equilibrium o Technological Improvement o New Technology raises marginal