Saving and Investing

1
Saving and Investing

• Hey, check out this story.

2
Say I told you at a football game that at the end
of regulation the score was 6 to 6. Farm out,
like, out of state, right? Just because the score
is tied can we say that both teams scored their
points in the same way? They may, but they may
not have. Each team may have their score made up
differently. Maybe one team scored a safety 3
times and the other team kicked 2 field goals.
At the end they had the same score but the scores
are composed of different parts. In economics we
often talk about things being equal at the end of
the day. But the things that are equal are made
up of separate parts. One example of this is
found in the model of supply and demand. At the
competitive output the quantity demanded equals
the quantity supplied. But demand refers to the
buyer side and the things that motivate buyers
and supply refers to the seller side and the
things that motivate sellers. The motivations
are not exactly the same. Another example would
be saving and investment. The two are equal in
the national economy. But saving refers to that
part of income that is not consumed or taxed
away. Saving can take the form of stocks, bonds,
mutual funds, and cds, among other things.
Investment includes business purchasing newly
made equipment, machines and buildings. New
residential construction is also included.
Saving and investment have different pieces, or
components.
3
Lets start with some definitions. Saving in
economics is defined as current income minus
current spending. The saving rate saving /
income. Wealth the value of assets minus value
of liabilities. This is sometimes called net
wealth. Assets anything of value someone
owns. Liabilities debts one owes. What are some
examples of assets?....................... What
are some examples of liabilities?.................
.......
4
Stocks and flows Some variables of interest in
economics are stocks and some are flows. To
understand the difference it can be useful to
consider a number line with the date, or time in
a more general sense, as the value on the line.
Time
now
later
Say you have to be at work now and you arrive at
now and then you leave at now. What will your
income be for now? Nothing! The reason for this
is that you actually have to work for a while
after the time now. Income is a flow variable
and this means you have to have an interval of
time in order to measure the value. But, if you
work from now until later you will probably earn
some income.
5
A stock variable is one that can be measured at a
point in time. An example of this could be the
number of earrings you have at home right now.
You could also count how many you have later.
The amount can be different. Saving is a flow,
income is a flow and spending is a flow. Wealth
is a stock, assets are a stock, and liabilities
are a stock. Changes in stock variables are
actually flow variables. A special asset is
savings (Note the s at the end of savings).
Savings represent that part of income kept as
cash, or maybe in a savings account or checking
account. Another asset might be a particular
companys stock, which would have been originally
purchased with saving in a period. A capital gain
is flow variable that means an assets value
later in time is higher than it was earlier in
time, and a capital loss is the opposite.
6
How can you become wealthier without having to
work any more hours than you currently work (Even
if you work zero hours)? Spend less! Change in
wealth saving capital gains capital
losses. So, saving can make each one of us more
wealthy. It is up to us. Why people save? An
economic story. 1) life-cycle saving some
people do not spend all they make in one period
because they know in a later period they will not
have enough income to buy all they want then. So
this saving is for a long term objective.
Examples here include saving for retirement, or
maybe for a childs college education. 2)
Precautionary saving this is saving for
protection against unexpected setbacks like
illness or an apostrophe you know, like if the
roof caves in.
7
3) Bequest saving the saving so you can leave
an inheritance. The authors point out what I
think is a really interesting point many people
choose to save for one of the three reasons
listed. BUT (and you can see this is a very big
but, for emphasis), how much is saved is
influenced by the real rate of interest.
Example Say I go out every Thursday night and
spend 20. If I do not go out and spend this
money and if I save it, then I am missing out on
some part of life right now! But, I can use the
saving later. The higher the real rate of
return, the more likely it is that folks will
give up the Thursday night out.
8
Saving

• Here we study some accounting at the national
  economy level.

9
Some definitions You may recall we said Y
C I G NX and this meant that the production
or income earned could be thought of as made up
of consumption of households, investment in
capital goods by business, government spending
for goods and services and net exports by the
rest of the world. Assume a closed economy Here
we will assume a closed economy, one with no
trade with other countries and thus no imports or
exports. We make this assumption now not because
it is true, but because we want to highlight
certain details without the added complication of
international trade. This means Y C I G,
or our production in a year can be broken up into
consumption goods, investment goods and
government goods (all are really goods and
services).
10
Y C I G can be re-arranged to have Y - C -
G I. Now, Y - C - G says take away from the
national income the consumption of households and
the government spending on goods and services.
HEY WAIT, if there is any income left after
spending at households and governments, then
there has been saving. By definition saving, S,
Y C G. Thus, Y - C - G S I and so
saving equals investment in an economy. This is
why folks always harp on savings in America. We
need savings so that investment can occur. An
interesting trick You know that if you have an
equation you can add and subtract a number from
the equation and the equation is still true
11
If Y - C - G S , then also S Y - C - T T -
G, where T stands for net taxes, meaning the
taxes we pay minus any money we get back in
transfers from the government. Now, S Y - C -
T T - G means saving can be broken into two
parts, Y - C - T private saving, and is made up
of business saving (often called retained
earnings) or household saving after consuming and
paying taxes, and T - G public saving
(government saving) in a general sense.
12
What we have come up with so far is private
saving government saving investment. Now if
government saving is negative, meaning T - G lt 0,
or taxes are less than government spending, or we
have a budget deficit, then investment will be
dragged down unless the household sector picks up
the slack. Similarly a budget surplus, T - G gt 0,
means investment can be higher, or the household
saving rate can be lower. Can households have
negative saving? Sure, consumption and taxes
would have to be greater than income - maybe by
using credit cards - and the same problem of a
budget deficit would occur.
13
Saving and Investing

• Financial Markets

14
Starting a Business My daughter started a
lemonade stand a few summers back. Wow, did she
get into it. My father in-law built a wooden
stand and shipped it to us. We had to assembly
it, but it works great. She used one of our
pitchers to mix the lemonade in and poured out
into cups. When sales picked up, she bought a
big cooler. So why am I telling you this story?
Why not! The cooler and the stand are capital
goods. My daughter had to organize production
and she even had to manage labor when her friend
Emma came over and worked at the stand.
15
I would like to start a retail golf merchandise
store. I even called a company once Club House
9 is the name of the joint. But I needed a boat
load of cash to get started. I would have had to
get display cases, cash registers and other
things. These things are called capital goods
and to purchase them would be called investment.
In the Y C I G NX equation for GDP the I
is for just the type of investment I am referring
to. I could have been contributing to GDP
through I. WOW! What were my options to make my
part of I? I could have used my own saving. S
I! Well, I didnt have any at the time, so I
thought about other people. I thought inside my
head - do other people have some saving they
would give to me for investment?
16
I eventually put my dream to have a golf store on
hold. Plus I got hooked on teaching. One thing
I have learned is that financial markets have
sprung up to help move savings from some so that
others may invest, and there are organizations
that assist in the process (called financial
intermediaries.) The Bond Market is a system
where folks who want to invest in capital goods
borrow money from savers. A bond is a
certificate of indebtedness that specifies the
obligations of the borrower to the holder of the
bond. Both businesses and governments issue bonds
borrow and typically they pay back the amount
borrowed (the principal) and some interest.
17
The stock market can be used to bring savers and
investors together. The savers are asked to
become an owner of the company by putting up
money and their reward will be part of the future
profits of the company. Now, the part of the
stock market that is relevant here is the primary
market. This is when the company issues new
shares. The company gets the funds for
investment in capital goods. The stock market
stuff you typically hear about is the secondary
market. This is where people like you and me
trade our ownership shares. This part is
important activity for reasons we wont get into
here. Banks are a financial intermediary and one
function they have is taking the savings of some
and lending out to others who want to start or
expand a business.
18
A mutual fund is an institution that sells shares
to the public and uses the proceeds to buy a
selection of various types of stocks and
bonds. At this stage of the story the mutual fund
is less important for investment sake. The
mutual fund is important in the secondary market
because folks with very little saving can buy
into the fund and participate in the market as a
part owner. In the past in this class folks have
had trouble understanding saving and investment,
or some feature of the discussion. In the
accounting sense S I. But the two are made up
of different items. In the end they are equal,
but the parts are very different. S is what is
left after households consume and pay taxes and
what part of taxes government has not spent.
Investment is done by businesses and is the
purchasing of capital goods you know,
computers, machines, buildings and the like.
19
Loanable Funds
20
Overview We saw in the national income accounting
that S I and then as we thought of a couple of
examples of business we saw that when a firm
(Okay, a potential firm) needed to buy capital
goods (investment) somehow saving had to be
found. In this section and the next I will
present a model of loanable funds. The model is
a mechanism used to explain how financial markets
coordinate the economys saving and
investment. Because we will use a model of a
market, we will have supply and demand. The
supply and demand here are special. Remember, by
the way, that models are simplifications of the
real world, but designed to highlight features of
the world.
21
The Supply of Loanable Funds What can people do
with their income? In a broad sense we say they
can consume goods and services, pay taxes, or
save. And just as if you look at different
people the consumption patterns may be different,
different people have different saving
patterns. Some people have more cars and less
house, some are the opposite. Some have big
checking accounts and few bonds, some are the
opposite. Whatever the form of saving, here we
talk about saving. Saving will be represented by
the supply of loanable funds. In general we will
have 3 items that influence the amount of
loanable funds from a supply perspective. Two of
these influences I will informally call shifters
because when they change they shift the supply
curve and the other one I will call a move
alonger because when it changes there is a
movement along a supply curve.
22
The move alonger - The Real Interest Rate I will
use r to represent the real rate of interest,
which you remember to be the nominal rate minus
the inflation rate. A few slides ago I mentioned
you can use your income to consume or save (or
pay taxes). Why save? Just go pig city and
consume all the income. Life is good, enjoy.
Billy, what did you say? Did you say - what
about the future, the proverbial rainy day? Good
Billy, you are catching on. People save for
things in the future (we saw three reasons
before). Saving is just giving up consumption
today so that consumption can occur later. Who
would give up a coke today if I pay you a coke
next year. Not many of us will give up today for
the same amount next year. But if we can get a
positive return what we gave up plus some -
then we might give up today. In other words, we
would save.
23
In fact, the higher the real rate of interest,
the more we expect to see a group save. This is
summarized in the graph below as an upward
sloping supply of loanable funds curve.
Here S represents the supply of loanable funds
and Q is loanable funds in general.
r
S
r2
r1
Q
Q1 Q2
24
Special Language page I didnt make the following
up, but I hope you understand it when you are
finished reading this page. On the previous page,
the way we look at the graph and talk about it
are the following. If the r should rise from r1
to r2 (note I mention r changing first) then Q
will change from Q1 to Q2. There is movement
along the curve because r has changed and the
movement from Q1 to Q2 is called an increase in
the quantity supplied. Similarly, there would be
a decrease in the quantity supplied if the
interest rate fell. Note, at this time I did not
say why the interest rate might change.
25
Supply Shifters, or things that can lead to a
change in supply. Tax rates on saving in the form
of taxes on the interest earned and the level of
the government budget are two items that we
consider at this time as factors that can lead to
shifts in the supply curve. Lets consider each
idea next, shall we? If you save 1 today and r
is 10 then next year you will have 1.10 of
purchasing power. A certain number of folks will
say, dude and dudettes, with this rate we should
save the amount X. But now lets add in the idea
that the government places a tax on the interest
we earn. If the tax rate is 100 most say, well
that is like shoveling shtuff against the tide,
so we will save less than X. Now the tax rate on
saving is usually not 100, but we can see the
higher the tax rate the more we could expect
saving to fall. The converse is also true. The
lower this tax rate is the more saving there
would be.
26
In this graph, if r is r2 and the tax rate on
saving is zero then I tell you the relevant
supply is S1. If the tax rate is increased the
supply of loanable funds will decrease and this
shows up as a shift to the left of the supply
curve here to S2.
Note here that the supply curve shifted but the
interest rate of record is still r2 at this time.
On the Q axis we have a new Q Q1 not Q2 but
in general we say there has been a decrease in
supply. You will notice I did NOT say a decrease
in the quantity supplied because we reserve that
language for when the real interest rate changes
S2
r
S1
r2
r1
Q
Q1 Q2
27
Summary of tax rate impact on supply curve If tax
rate on interest earned from saving is made
higher the supply shifts to the left. If tax rate
on interest earned from saving is made lower the
supply shifts to the right. Government budget
impact Remember that the supply of loanable funds
is really a supply of saving. Saving in the
country is private saving and public saving.
Recall public saving is really the concept of
looking at the government budget situation. If
T G gt0 we say it is a miracle, no, I mean a
government surplus. If T G 0 we have a
balanced budget, and if T G lt 0 we have a
budget deficit.
28
In general we talk about the state of public
saving as T G, but when we get specific T G
is positive, negative, or zero. Now lets
consider a change in the budget situation. If
the budget starts in surplus and then the surplus
becomes even larger the saving level in the
economy would go up and the supply of loanable
funds would shift to the right. Here is a similar
story. Say the budget starts in a deficit and
then the deficit shrinks. The supply of loanable
funds would increase and the curve would shift to
the right. The budget is still in deficit, but a
smaller one so the supply of loanable funds
becomes larger than what it used to be.
29
T - G
deficit
balance
surplus
I have this arrow to show that if the deficit
gets smaller or the surplus gets bigger the
supply of loanable funds will shift to the
right. What would you write if I had an arrow
pointing to the left? (Parker, you lazy bum,
why dont you write something, is not something
you should write here!)
30
The demand for loanable funds People who want to
buy capital goods, what we mean by investment in
this economics class, have to come up with funds.
In my story in a previous section I had to find
others who saved and I would borrow from them. We
will say folks who want to invest demand loanable
funds. Hey, I need to come clean about
investment. I have said it is businesses buying
tools to assist in production. This much is
true. But investment includes new home
construction. Households buy homes. Before I
said households undertake consumption. Well, the
one item households take that is not consumption
is new residential homes. This is part of
investment. For GDP, investment includes new
homes. For our purposes in terms of loanable
funds, businesses that want investment demand
loanable funds and so do people who want to buy
homes.
31
The demand for loanable funds will depend on two
things one is a shifter and one is a move
alonger. The real interest rate r is the move
alonger. Here is the story. The higher r is the
more folks have to pay back. The more they have
to pay back the less inclined they are to
undertake the action. This leads to a demand for
loanable funds as we see below.
r
The higher the r, the lower the quantity
demanded. Similarly, the lower the r, the
greater the quantity demanded.
r2
D
r1
Q
Q2 Q1
32
Investment tax credit An investment tax credit is
the shifter. When businesses invest in capital
goods they do so because they think they will
earn profits. In fact, at a given interest rate,
X dollars of funds will be demanded because that
is all that will turn out profitable. What an
investment tax credit does is allow businesses to
reduce the tax they owe if they undertake
investment. This would mean that some projects
that were not profitable may now be profitable
because of the tax break. The demand for
loanable funds would shift to the right. If
investment tax credits are reduced then we would
expect the demand for loanable funds to fall and
the curve shift to the left.
33
Loanable Funds
R
Demand shifts right with an increase in the
investment tax credit
R2
Demand shifts left with a decrease in the
investment tax credit.
D
R1
Q
Q2 Q1
34
Loanable Funds

• Here we look at the market interaction

35
r
S1
r1
D1
Q
Q1
36
Some have made the claim that you can teach a
parrot economics. Just teach the parrot to say
supply and demand. Well, this teaching would be a
good start. On the previous screen we have a
start. Notice that demand and supply are
positioned and with these positions we get the
market outcome of r1 and Q1. r1 is the real rate
of interest and Q1 is the amount of loanable
funds traded between the savers and the
investors. (Hey, is Q1 the supply amount or the
demand amount? It is both at this one r) We know
the position of supply or demand could change and
we would thus get a new r and Q. Lets turn to
that next. Say the government changes the level
of the investment tax credit to a higher level.
This will shift the demand for loanable funds to
the right.
37
R
S1
r2
r1
D2
D1
Q
Q1 Q2
38
Here is how I like to look at the graph on the
previous screen. 1. Start at the initial
equilibrium when we have D1 and S1, r1 and Q1
result. 2. The increase in the tax credit has
the demand shift to D2. D1 is no longer
relevant. You will notice I have a dashed line
at the height r1 and it shows the amount the
demand shifted. This amount also now represents
a shortage of loanable funds. Shortages cause
prices to rise. Here the price is the interest
rate. r rises to r2. 3. Note the supply curve
did not change here. But as r rises the quantity
supplied rises and the quantity demanded falls
from its new higher level to eliminate the
shortage. Overall, the Q in the market rose to
Q2.
39
Summary An increase in the investment tax
credit raises the interest rate and raises the
amount of loanable funds traded. Next lets look
at the impact on the market when the tax rate on
interest from saving is changed we will do a
reduction in the tax rate. Then you can study the
government budget changing on your own and I can
see how well you did on the test.
40
r
S1
S2
r1
r2
D1
Q
Q1
Q2
41
Here is how I like to look at the graph on the
previous screen. 1. Start at the initial
equilibrium when we have D1 and S1, r1 and Q1
result. 2. The reduction in the tax rate on the
interest from saving has the supply shift to S2.
S1 is no longer relevant. You will notice I have
a dashed line at the height r1 and it shows the
amount the supply shifted. This amount also now
represents a surplus of loanable funds.
Surpluses cause prices to fall. Here the price
is the interest rate. r falls to r2. 3. Note
the demand curve did not change here. But as r
falls the quantity supplied falls from its new
higher level and the quantity demanded rises to
eliminate the surplus. Overall, the Q in the
market rose to Q2.