Chapter 8SAVINGS, CAPITAL FORMATION, and

FINANCIAL MARKETS

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ECONOMY IN THE LONG RUN

• Ants work and save the corn for winter

Saving

• Ants calculate and they have 5 corns

• During Fall season, they consume 2 corns for daily needs. In other words, their saving is 3 corns.

• So, the saving rate is 3 divided by 5 or 60%

What will happen to Grasshopper?

• The Grasshopper has been suffering during winter. No Saving, No Assets.

• No Assets means does not have anything. So, how to survive?

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Going for Debt

• The Grasshopper has to go to ants for corn. The grasshopper owes ants a corn, which is usually called as Liabilities

• But yet, Grasshopper is still poor because it does not have any wealth (even it is negative!). Why? Zero Assets, 1 liability.

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• If Saving shows the number of assets, the increasing of saving will increase the Wealth

• ASSETS: All the belongings, including savings

• SAVINGS , and ASSETS .

Wealth is ASSETS minus LIABILITIES. Then,

SAVINGS , ASSETS , and WEALTH .

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What is the conclusion?

• Higher saving rates today lead to faster accumulation of wealth.

• The Wealthier is the nation, the higher its standard of living.

• Remember Question 8 chapter 7?

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Problems 1

• Corey’s initial balance sheet:

• Net worth is equal to total assets minus total liabilities, which equals $1700.

ASSETS LIABILITIES

Bike $300 Credit card debt $150

Cash $200 Electric bill due $250

Baseball card $400

Checking acct.

balance

$1,200

TOTAL $2,100 $400

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b. The card is worth zero rather than $400. Assets decline to $1700, liabilities are unchanged, net worth falls by $400 to $1300. This is an example of a capital loss; no saving (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 an existing asset was set off against an existing liability.

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How about if there are many ants?

• If many ants in one region, the aggregate (the accumulation) of the savings is called as country saving or NATIONAL SAVING

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How to calculate NATIONAL SAVING?

• First, we have to know the “PRODUCTION”.• Y = C + I + G + (X-M)

• Let assume there is no trade or Export – equal to Import, (X-M) will be equal to Zero.

• Y = C + I + G

• If Saving is equal to Income minus expenditure (like the corn harvested minus corn consumed) and I is not a spending, the formula is:

• S = Y – (C+G)

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Private Vs Public

• Private saving is the amount

household and business save from

private sector

Public saving is the amount

government save from public sector

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Private has to pay tax to government.

So, Private Saving is equal to Income (Y) minus Tax (T) minus Consumption (C) or:

Sprivate = Y – T – C

Government takes the tax and

distribute it to Public purpose such as Infrastructure, Education, Health Security, etc.

The process of Private tax to Public goods is called as TRANSFER PAYMENT

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• The spending of Government on Public Services is called as Government Expenditure (G)

• The Public Saving is equal to Tax (T) minus Government Expenditure

– Spublic = T – G

Therefore, National Saving is the aggregate of Private sector plus Public Sector or:

Sprivate + Spublic.

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National Saving, Investment, and Capital Formation

• Saving shows the amount of asset we have.

• One of the purpose is long run objective such as Investment

• In other words, Saving shows the provided funds needed for Investment

• Investment will encourage economic growth. Increasing economic growth will increase standard of living

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Illustration

• Ants think they can harvest extra 5 corns if they have mechanical cutting equipment

• = 10 x

• How ants can get the equipment?

– By using the saving!

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What are the factors that increase the willingness to invest?

• A decline in the price of new capital goods

• A decline in the real interest rate

• Technological improvement that raises the marginal product of capital

• Lower taxes on the revenues generated by capital

• A higher relative price for the firm’s output

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NOTES• The supply of national saving depends on the saving

decision of household, business, and government

• Demand of saving is the amount of business want to invest in new capital

• An increase in government budget deficit will reduce national saving and investment, and raise interest rate.

• TRADE-OFF between SAVING and FINANCIAL MARKET

• Fiscal Policy: Taxation, Seigniorage, Borrowing Money, Consumption of Reserves

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Question 9 Chap. 8

– The investment tax credit effectively lowers the price of new capitalgoods to the firm by 10%. Firms’ willingness to invest increases,raising the demand for saving (I). The real interest rate and theequilibrium quantities of investment and national saving rise as thedemand for saving (I) curve shifts to the right.

– Increased public saving raises national saving. The supply of saving (S)curve shifts right. The real interest rate falls and the equilibriumquantities of investment and national saving rise.

– Increased productivity of new capital goods makes investment moreprofitable. The demand for saving (I) curve shifts to the right, raisingthe real interest rate and the equilibrium quantities of investment andnational saving.

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– The increased tax on corporate profits reduces the after-tax return tocapital investments (a greater share of the income earned by capitalgoes to the government). Firms become less willing to invest, so thatthe demand for saving (I) shifts leftward. Public saving is unchangedby assumption, so the supply of saving curve (S) does not shift. Thereal interest rate and the equilibrium quantities of investment andnational saving all decline.

– Increased precautionary saving raises national saving. The supply ofsaving (S) curve shifts right. The real interest rate falls and theequilibrium quantities of investment and national saving rise.

– Increased cost of capital decreases a firm’s willingness to invest,lowering the demand for saving (I). The real interest rate and theequilibrium quantities of investment and national saving fall as thedemand for saving (I) curve shifts to the left.

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