Week 2

Lectures 3 & 4
Saving and Wealth

Reference: Bernanke, Olekalns and Frank - Chapter 2

Key Issues
Definition and Measures of Saving
Saving and Wealth
Motives for Saving
Investment and Capital Accumulation
Saving, Investment and the Real Interest Rate

Learning objectives:

What is the relation between saving and wealth?

For what reason do people save?
What has happened to the household saving ration
in Australia?
What does national saving mean?
How are investment and capital formation related?
What role does the interest rate play in
determining saving and investment?

Saving
Saving = current income current spending
Saving rate =

Saving
Income

Saving is a flow variable

If saving is positive then assets are being accumulated
If saving is negative then assets are being decumulated or liabilities (debts) accumulated
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Capital Gains and Losses

Fluctuations in the market value of assets. Capital gains
or capital losses can have an important effect on net
wealth
sell shares, 1, but now 2,

Change in Wealth = Saving + Capital gains Capital

losses
Change in Wealth = W = W W(-1)
W = W(-1) + S + Net Capital Gains
Assets, liabilities and wealth are stock variables
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Wealth
Net Wealth = Value of Assets Value of Liabilities
Balance Sheet
Assets
$
Liabilities
$
House (m.v.)
700,000
Mortgage
450,000
Car (m.v.)
10,000
Credit Card
3,500
Bank Account
3,500
Shares (m.v.)
25,000
Furniture (m.v.)
15,000
Total
753,500
Total
453,500
Net Wealth = 300,000

m.v. = market value

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Motives For Saving

1. Life-Cycle Saving
Typically people only work for some fraction of their
lifetime, e.g. might work from age 20 to 60.
Consume over your entire lifetime, e.g. might expect to
live to 80.
Save during your working life to provide for
consumption during retirement.

Households might also save for other costly items such as:
House deposit
Education expenses
2. Precautionary Saving
Saving can be used as a form of insurance against
unexpected declines in income or unexpected increases in
consumption, e.g. temporary unemployment, medical
expenses

3. Bequest Saving
People save to leave a bequest or inheritance for their
heirs and dependents

Saving and the Real Interest Rate

We expect the level of saving will increase with higher
real returns to various assets.
We will focus on the real interest rate r as being most
relevant to the saving decision.
Other things equal (ceteris paribus) we expect saving to
increase with the real interest rate.

S(r)
r

Saving

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Psychology and Behavioral Motives for Saving

Standard macroeconomic model assumes that individuals
and households choose a level of saving that maximizes
their long-run welfare
In reality people may lack sufficient self-control or
willpower to undertake an optimal level of saving.
The consumption benefits of saving arise far into the
future, but costs in terms of forgone consumption are
immediate.

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Factors that tend to reduce saving

Availability of consumer credit, e.g. home equity
loans
Demonstration effects. High consumption levels of
our neighbors may influence us to consume more and
save less
Government provision of retirement benefits may lead
to less private saving for retirement. Reducing ones
own saving in response to government retirement
benefits may be rational behavior

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If people cannot make rational savings decisions what

can be done?
Compulsory superannuation saving.
Hard to justify this policy of compulsory saving if we
believe that individuals make fully rational saving
decisions.
Compulsory saving schemes will only increase total
saving if individuals do not reduce their voluntary saving
by an equal amount in response.

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Household saving ratio for Australia

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National Saving
Saving is undertaken by:
Households
Business
Government
National saving measures aggregate saving in an
economy

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National Accounting Identity

Y = C + I + G + NX
Assume NX=0
Y=C+I+G
Saving = Current income current spending
consumer

S=YCG
income

govt expenditure

We exclude I because by definition it is spending that

provides for future needs not current ones.

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Durable Goods
In reality not all of C and G are for immediate needs.
Consumer durables (e.g. cars, furniture, appliances)
provide a flow of consumption services over a period of
time.
Government purchases of durable goods (e.g. roads,
bridges, schools, other infrastructure) will provide a
future flow of services.
Known as public capital
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Private and Public Components of Saving

Private Saving
Households
Business
Public Saving
Government

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S=YCG
S=YCG+TT
T = taxes paid by private sector to government
less
transfer payments from government to private sector
less
interest payments from government to private sector
bond holders
Transfer payments: payments the government makes to
the public for which it receives no current goods or
services in return
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S = Y C G + T T
S = (Y T C) + (T G)
S = Private saving + public saving
Private Saving = Y T C
Saving by households and business (i.e. retained earnings)

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Public Saving = T G
Public Saving is equal to the Budget Surplus
T G = Budget Deficit/Surplus

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2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
-1
% of GDP

Government Budget Balance (cash balance)

3

-2

-3

-4

-5

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Investment and Capital Formation

National saving provides the resources for investment.
Investment is the purchase of new capital goods.
Influences on the level of Investment
Cost of capital
Should Tiger Airlines buy an additional plane?
Costs vs. Benefits
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3 Components to Cost of Capital (The following is more

technical than in BOF)
1. Suppose Tiger Airlines have to borrow the funds to
buy the new plane at the nominal interest rate = i
The dollar price/cost of the new plane =

PK

(Note: even if they used retained earnings there would be

an opportunity cost = i )
2. Physical depreciation rate on plane =
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3. Over time the price of the plane may rise or fall

(capital gain or capital loss) = PK

Net cost of owning a plane for one year.

Cost of capital = price of capital (begin year)
+ interest cost
- price of (depreciated) capital (end year)
Cost of capital =

PK iPK (1 )[ PK PK ]

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Some Algebra
Cost of capital =
or
Cost of capital =
or if

PK
PK

PK iPK (1 )[ PK PK ]

PK
]
PK [1 i (1 ) (1 )
PK

is small

Cost of capital =

PK
)
PK (i
PK

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Finally let the price of capital goods rise at the general

rate of inflation

Cost of capital =
or since

PK

PK

PK (i )

r i

Cost of capital =

PK (r )

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Summary
Model suggests that two important influences on Tiger
Airlines investment decision will be:
Price of the capital goods
Real interest rate
Other things equal (ceteris paribus) a rise in the real
interest rate will make investment less attractive.
Other things equal (ceteris paribus) a rise in the price of
capital goods will make investment less attractive.
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Cost vs. Benefits

The benefit of a new plane is value of the additional
output it provides to Tiger Airlines.
The change in output for an increase in capital is called
the marginal product of capital (MPK).
Tiger Airlines will invest provided:
Value of marginal product of capital Cost of capital

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Saving, Investment and Financial Markets

In an economy with no access to international capital
markets:
National Saving = Investment.
The supply of saving by HH, businesses, and government
and the demand for saving (for investment) by business
are equated by the financial markets.

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Model
Saving is an increasing function of the real interest rate
Investment is a decreasing function of the real interest
rate
r
S(r)

I(r)
S, I
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Initial Equilibrium

I
Saving and Investment
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New Technology

S
r`
r

I`
I
Saving and Investment
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Initial Equilibrium

I
Saving and Investment
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Increase in Budget Deficit

S`
r

S
r`
r

I
Saving and Investment
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Crowding Out
An increase in the government budget deficit will reduce
private investment spending
In the above model a larger deficit reduces the supply of
saving (savings curve shifts inwards) and drives up the
real interest rate. The higher real interest rate makes
investment less attractive and causes a move along the I
curve.

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