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Lecture Principles of economics (Asia Global Edition) - Chapter 19

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After studying this chapter you will be able to: Explain the relationship between savings and wealth, identify and apply the components of national saving, discuss the reasons why people save, discuss the reasons why firms choose to invest in capital rather than financial assets, analyze financial markets using the tools of supply and demand.

Saving, Capital Formation, and Financial Markets Chapter 19 McGraw­Hill/Irwin Copyright © 2015 by McGraw­Hill Education (Asia). All rights reserved 19­1 Learning Objectives Explain the relationship between savings and wealth Identify and apply the components of national saving Discuss the reasons why people save Discuss the reasons why firms choose to invest in capital rather than financial assets Analyze financial markets using the tools of supply and demand 19­2 Savings and Wealth • Saving is current income minus spending on current needs – • The saving rate is saving divided by income Wealth is the value of assets minus liabilities – – – Assets are anything of value that one owns Liabilities are the debts one owes The balance sheet is a list of an economic unit’s assets and liabilities • • Specific date Economic unit (business, household, etc.) 19­3 Individual Balance Sheet, 1/1/14 Assets Cash Checking account Shares of stock $80 1,200 1,000 Car (market value) 3,500 Furniture (market value) Total Liabilities Student loan Credit card balance $3,000 250 500 $6,280 $3,250 Net worth $3,030 19­4 Flow Values and Stock Values • A flow value is defined per unit of time – – • Wealth ■ Debt The flow of savings causes the stock of wealth to change – • ■ Spending ■ Wage A stock value is defined at a point in time – • Income Saving Every dollar a person saves adds to his wealth A high rate of saving today leads to an improved standard of living in the future 19­5 Capital Gains and Losses • 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 Change in wealth = Saving + Capital gains – Capital losses 19­6 US Stock Prices, 1960 - 2004 19­7 The Bull Market of the 1990s • Stock ownership increased – – – • Direct purchases Mutual funds Pension and retirement funds Stock prices rose rapidly – Capital gains on stocks increased household wealth • • May have decreased household savings Stock market declined, 2000 – 2002 – – Household savings remained low Value of privately-owned homes increased rapidly 19­8 National Savings • Macroeconomics studies total savings in the economy – – • Household savings is one component Business and government savings are other parts Start with the definition of production and income for the economy Y = C + I + G + NX Y = aggregate income C = consumption expenditure I = investment spending G = government purchases of goods and services NX = net exports 19­9 Calculate National Savings • • Assume NX = for simplicity National savings (S) is current income less spending on current needs – • Current income is GDP or Y Spending on current needs – – Exclude all investment spending (I) Most consumption and government spending is for current needs • For simplicity, we assume all of C and all of G are for current needs S=Y–C–G 19­10 Maximize Lifetime Well Being • Psychologists suggest individual self-control may be too weak to produce rational outcomes – • Smoking, obesity, gambling, and spending Devices to support savings – Make savings automatic and withdrawals costly • • Penalties for early withdrawal of IRA funds Easy borrowing supports high levels of current spending – – Credit cards Home equity loans 19­26 Explaining U.S Household Savings Rate • Savings rate may be depressed by – – – – – – Social Security, Medicare, and other government programs for the elderly Mortgages with small or no down payment Confidence in a prosperous future Increasing value of stocks and growing home values Readily available home equity loans Demonstration effects and status goods 19­27 Investment and Capital Formation • • Investment is the creation of new capital goods and housing 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 19­28 Larry and the Lawn Mower • Larry's lawn care business plan – Cost of lawn mower = $4,000 • • – Net revenue = $6,000 per summer • • • Interest on loan = 6% Assume the mower can be resold for $4,000 Taxes = 20% Larry could earn $4,400 per summer after tax working elsewhere Cost – Benefit Principle indicates whether Larry should start the business 19­29 Larry and the Lawn Mower • Business plan analysis Net revenue $6,000 Less taxes (20%) $1,200 Less opportunity cost $4,400 Equals VMP of lawnmower $400 Less interest (6%) $240 Equals net benefit $160 • Larry should start the business 19­30 The Investment Decision • Two important costs – – Price of the capital goods Real interest rates • • Opportunity cost of the investment 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 19­31 Investment in Computers • Purchases of new computers and software is more than 2.5% of GDP – • 24% of all private nonresidential investment Computer investment increased faster than other capital goods – Unique attributes of computers are • The declining price of computing power – • Computing power per dollar doubles every 18 months The increase in the value of the marginal product of computers 19­32 Investment in Computers, 1960-2010 • Computer technology may have driven increases in productivity since 1995 19­33 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 Demand for investment (I) is the amount of savings borrowed at each possible real interest rate – The quantity demanded is inversely related to r 19­34 Equilibrium interest rate equates the amount of saving with the investment funds demanded • • • If r is above equilibrium, there is a surplus of savings If r is below equilibrium, there is a shortage of savings Real interest rate (%) Financial Market Savin gS r Investm ent I S, I and Saving investment 19­35 Financial Markets Are Markets • Financial markets adjust to surpluses and shortages as any other market does – • Equilibrium Principle holds Changes in factors other than real interest rates will shift the savings or investment curves – New equilibrium 19­36 Technological Improvement • Real interest rate (%) S – F r' r New technology raises marginal productivity of capital E I' – I – – Saving and Investment Increases the demand for investment funds Movement up the savings supply curve Higher interest rate Higher level of savings and investment 19­37 Government Budget Deficit Increases Real interest rate (%) S' S • F r' Government budget deficit increases • • E r • I • • Saving and investment Reduces national saving Movement up the investment curve Higher interest rate Lower level of savings and investment Private investment is crowded out 19­38 Increase National Saving • Policymakers know the benefits of increased national saving rates – Reducing government budget deficit would increase national saving • – Increase incentives for households • • • Political problems Consumption tax Reduce taxes on dividends and investment income Higher national saving rate leads to greater investment in new capital goods and a higher standard of living 19­39 Saving, Capital Formation, and Financial Markets Financial Markets Investment and Capital National Saving Private Saving Public Saving Wealth Capital Gains and Losses Low Household Saving Interest Rate Government Budget 19­40 ... of existing assets • Car accident damages bumper and front headlight Change in wealth = Saving + Capital gains – Capital losses 19 6 US Stock Prices, 196 0 - 2004 19 7 The Bull Market of the 199 0s... for current needs • For simplicity, we assume all of C and all of G are for current needs S=Y–C–G 19 10 National Savings, 196 0 - 2011 • Since 196 0, US national savings rate has been 11– 21% whereas... rate of saving today leads to an improved standard of living in the future 19 5 Capital Gains and Losses • Wealth changes when the value of your assets change – Capital gains increase the value of

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