CHAPTER 21
What is saving and why does it matter?©D. Hurst/Alamy Stock Photo
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Explain the relationship between saving and wealth.
2. LO2Discuss the reasons people save and how psychological factors influence saving.
3. LO3Identify and apply the components of national saving.
4. LO4Discuss the reasons firms choose to invest in capital.
5. LO5Analyze financial markets using the tools of supply and demand.
You’ve probably heard Aesop’s fable of the ant and the grasshopper. All summer the ant worked hard laying up food for the winter. The grasshopper mocked the ant’s efforts and contented himself with basking in the sunshine, ignoring the ant’s earnest warnings. When winter came the ant was well-fed, while the grasshopper starved. Moral: When times are good, the wise put aside something for the future.
Of course, there is also the modern ending to the fable, in which the grasshopper breaks his leg by tripping over the anthill, sues the ant for negligence, and ends up living comfortably on the ant’s savings. (Nobody knows what happened to the ant.) Moral: Saving is risky; live for today.
The pitfalls of modern life notwithstanding, saving is important, both to individuals and to nations. People need to save to provide for their retirement and for other future needs, such as their children’s education or a new home. An individual’s or a family’s savings can also provide a crucial buffer in the event of an economic emergency, such as the loss of a job or unexpected medical bills. At the national level, the production of new capital goods—factories, equipment, office buildings, and housing—is an important factor promoting economic growth and higher living standards. As we will see in this chapter, the resources necessary to produce new capital come primarily from a nation’s collective saving.
Because adequate saving is so important to both ensuring families’ financial security and creating new capital goods, many people have expressed concern about the low saving rate of American households. Never very high by international standards, the U.S. household saving rate—the percentage of after-tax household income that is saved—declined from around 13 percent of household disposable income in the early 1970s to a low of 2.6 percent in 2005. (The household saving rate increased sharply during and following the 2007–2009 recession, before falling again to 3.4 percent in 2017.)
What was the significance of this precipitous decline? Alarmists saw the data as evidence of “grasshopperish” behavior and a threat to Americans’ future prosperity. The reality, as we will see, is more complex. Many American families do save very little, a choice that is likely to exact a toll on their economic well-being in the long run. On the other hand, household saving is only one part of the total saving of the U.S. economy, as businesses and governments also save. In fact, the total saving of the U.S. economy, called national saving, has declined much less dramatically than household saving during these years. Thus, if the United States is suffering a “savings shortfall,” it is much less severe than might be suggested by the figures on household saving only.
In this chapter, we will look at saving and its links to the formation of new capital. We begin by defining the concepts of saving and wealth and exploring the connection between them. We will consider why people choose to save, rather than spending all their income. We then turn to national saving—the collective saving of households, businesses, and government. Because national saving determines the capacity of an economy to create new capital, it is the more important measure of saving from a macroeconomic perspective.
We next discuss capital formation. Most decisions to invest in new capital are made by firms. As we will see, a firm’s decision to invest is in many respects analogous to its decision about whether to increase employment; firms will choose to expand their capital stocks when the benefits of doing so exceed the costs. We end the chapter by showing how national saving and capital formation are related, using a supply and demand approach.
SAVING AND WEALTH
In general, the saving of an economic unit—whether a household, a business, a university, or a nation—may be defined as its current income minus its spending on current needs. For example, if Consuelo earns $300 per week; spends $280 weekly on living expenses such as rent, food, clothes, and entertainment; and deposits the remaining $20 in the bank, her saving is $20 per week. The saving rate of any economic unit is its saving divided by its income. Since Consuelo saves $20 of her weekly income of $300, her saving rate is $20/$300, or 6.7 percent.
The saving of an economic unit is closely related to its wealth, or the value of its assets minus its liabilities. Assets are anything of value that one owns, either financial or real. Examples of financial assets that you or your family might own include cash, a checking account, stocks, and bonds. Examples of real assets include a home or other real estate, jewelry, consumer durables like cars, and valuable collectibles. Liabilities, on the other hand, are the debts one owes. Examples of liabilities are credit card balances, student loans, and mortgages.
Accountants list the assets and liabilities of a family, a firm, a university, or any other economic unit on a balance sheet. Comparing the values of the assets and liabilities helps them to determine the economic unit’s wealth, also called its net worth.
EXAMPLE 21.1Constructing a Balance Sheet
What is Consuelo’s wealth?
To take stock of her financial position, Consuelo lists her assets and liabilities on a balance sheet. The result is shown in Table 21.1. What is Consuelo’s wealth?
Consuelo’s financial assets are the cash in her wallet, the balance in her checking account, and the current value of some shares of stock her parents gave her. Together her financial assets are worth $2,280. She also lists $4,000 in real assets, the sum of the market values of her car and her furniture. Consuelo’s total assets, both financial and real, come to $6,280. Her liabilities are the student loan she owes the bank and the balance due on her credit card, which total $3,250. Consuelo’s wealth, or net worth, then, is the value of her assets ($6,280) minus the value of her liabilities ($3,250), or $3,030.
CONCEPT CHECK 21.1
What would Consuelo’s net worth be if her student loan were for $6,500 rather than $3,000? Construct a new balance sheet for her.
Saving and wealth are related, because saving contributes to wealth. To understand this relationship better, we must distinguish between stocks and flows.
STOCKS AND FLOWS
Saving is an example of a flow, a measure that is defined per unit of time. For example, Consuelo’s saving is $20 per week. Wealth, in contrast, is a stock, a measure that is defined at a point in time. Consuelo’s wealth of $3,030, for example, is her wealth on a particular date—say, January 1, 2016.
To visualize the difference between stocks and flows, think of water running into a bathtub. The amount of water in the bathtub at any specific moment—for example, 40 gallons at 7:15 p.m.—is a stock because it is measured at a specific point in time. The rate at which the water flows into the tub—for example, 2 gallons per minute—is a flow because it is measured per unit of time. In many cases, a flow is the rate of change in a stock: If we know that there are 40 gallons of water in the tub at 7:15 p.m., for example, and that water is flowing in at 2 gallons per minute, we can easily determine that the stock of water will be changing at the rate of 2 gallons per minute and will equal 42 gallons at 7:16 p.m., 44 gallons at 7:17 p.m., and so on, until the bathtub overflows.
The flow of saving increases the stock of wealth in the same way that the flow of water through the faucet increases the amount of water in the tub.
CONCEPT CHECK 21.2
Continuing the example of the bathtub: If there are 40 gallons of water in the tub at 7:15 p.m. and water is being drained at the rate of 3 gallons per minute, what will be the stock and flow at 7:16 p.m.? At 7:17 p.m.? Does the flow still equal the rate of change in the stock?
The relationship between saving (a flow) and wealth (a stock) is similar to the relationship between the flow of water into a bathtub and the stock of water in the tub in that the flow of saving causes the stock of wealth to change at the same rate. Indeed, as Example 21.2 illustrates, every dollar that a person saves adds a dollar to his or her wealth.
EXAMPLE 21.2 The Link between Saving and Wealth
What is the relationship between Consuelo’s saving and her wealth?
Consuelo saves $20 per week. How does this saving affect her wealth? Does the change in her wealth depend on whether Consuelo uses her saving to accumulate assets or to pay down her liabilities?
Consuelo could use the $20 she saved this week to increase her assets—for example, by adding the $20 to her checking account—or to reduce her liabilities—for example, by paying down her credit card balance. Suppose she adds the $20 to her checking account, increasing her assets by $20. Since her liabilities are unchanged, her wealth also increases by $20, to $3,050 (see Table 21.1).
If Consuelo decides to use the $20 she saved this week to pay down her credit card balance, she reduces it from $250 to $230. That action would reduce her liabilities by $20, leaving her assets unchanged. Since wealth equals assets minus liabilities, reducing her liabilities by $20 increases her wealth by $20, to $3,050. Thus, saving $20 per week raises Consuelo’s stock of wealth by $20 a week, regardless of whether she uses her saving to increase her assets or reduce her liabilities.
The close relationship between saving and wealth explains why saving is so important to an economy. Higher rates of saving today lead to faster accumulation of wealth, and the wealthier a nation is, the higher its standard of living. Thus a high rate of saving today contributes to an improved standard of living in the future.
CAPITAL GAINS AND LOSSES
Though saving increases wealth, it is not the only factor that determines wealth. Wealth can also change because of changes in the values of the real or financial assets one owns. Suppose Consuelo’s shares of stock rise in value, from $1,000 to $1,500. This increase in the value of Consuelo’s stock raises her total assets by $500 without affecting her liabilities. As a result, Consuelo’s wealth rises by $500, from $3,030 to $3,530 (see Table 21.2).
Changes in the value of existing assets are called capital gains when an asset’s value increases and capital losses when an asset’s value decreases. Just as capital gains increase wealth, capital losses decrease wealth. Capital gains and losses are not counted as part of saving, however. Instead, the change in a person’s wealth during any period equals the saving done during the period plus capital gains or minus capital losses during that period. In terms of an equation,
Change in wealth = Saving + Capital gains − Capital losses.
CONCEPT CHECK 21.3
How would each of the following actions or events affect Consuelo’s saving and her wealth?
a. Consuelo deposits $20 in the bank at the end of the week as usual. She also charges $50 on her credit card, raising her credit card balance to $300.
b. Consuelo uses $300 from her checking account to pay off her credit card bill.
c. Consuelo’s old car is recognized as a classic. Its market value rises from $3,500 to $4,000.
d. Consuelo’s furniture is damaged and as a result falls in value from $500 to $200.
Capital gains and losses can have a major effect on one’s overall wealth, as Economic Naturalist 21.1 illustrates.
The Economic Naturalist 21.1
How did American households increase their wealth in the 1990s and 2000s while saving very little?
On the whole, Americans felt very prosperous during the 1990s and, with a short pause around the relatively minor 2001 recession, the feeling of prosperity continued until the eve of the 2007–2009 recession. Measures of household wealth during this period showed enormous gains. Yet saving by U.S. households was quite low (and declining) throughout those years. How did American households increase their wealth in the 1990s and early 2000s while saving very little?
During the 1990s, an increasing number of Americans acquired stocks, either directly through purchases or indirectly through their pension and retirement funds. At the same time, stock prices rose at record rates (see the blue line in Figure 21.1). The strongly rising “bull market,” which increased the prices of most stocks, enabled many Americans to enjoy significant capital gains and increased wealth without saving much, if anything. Indeed, some economists argued that the low household saving rate of the 1990s is partially explained by the bull market; because capital gains increased household wealth by so much, many people saw no need to save. (Other proposed explanations include the increase in government saving during the 1990s, discussed below.)
FIGURE 21.1 Household Saving vs. Real Stock and Home Prices, 1975–2016.Changes in household saving often accompany changes in the opposite direction in measures of household wealth such as stocks and homes. As both stock markets and home values started declining in the later part of the 2000s, the household saving rate reversed its trend and started increasing.Source: S&P CoreLogic Case-Shiller Home Price Indices, http://us.spindices.com/index-family/real-estate/sp-corelogic-case-shiller; Economic Report of the President 2015; and the Federal Reserve Bank of St. Louis.
The stock market peaked in early 2000 and stock prices fell quite sharply over the following two years. It is interesting that U.S. households did not choose to save more in 2000 and the following years (see the green line in Figure 21.1), despite the decline in their stock market wealth. One explanation is that an even larger component of household wealth—the value of privately owned homes—rose significantly in 2000–2006, partly offsetting the effect of the decline in stock values on household wealth (see the red line in Figure 21.1).
More generally, as Figure 21.1 shows, changes in household saving often accompany changes in the opposite direction in measures of household wealth such as stocks and homes (for example, household saving and home prices during the 1970s and 1980s often moved in opposite directions). Indeed, the figure shows that as both stock markets and home values started declining in the later part of the 2000s, the household saving rate reversed its trend and started increasing. Household saving then peaked in 2012 when the housing market bottomed, and has since declined again, as both stock and home prices began rising again.
We have seen how saving is related to the accumulation of wealth. To understand why people choose to save, however, we need to examine their motives for saving.
RECAP
SAVING AND WEALTH
In general, saving is current income minus spending on current needs. Wealth is the value of assets—anything of value that one owns—minus liabilities—the debts one owes. Saving is measured per unit of time (for example, dollars per week) and thus is a flow. Wealth is measured at a point in time and thus is a stock. In the same way the flow of water through the faucet increases the stock of water in a bathtub, the flow of saving increases the stock of wealth.
Wealth can also be increased by capital gains (increases in the value of existing assets) or reduced by capital losses (decreases in asset values). The capital gains afforded stockholders by the bull market of the 1990s and the housing market of much of the 2000s allowed many families to increase their wealth significantly while doing very little saving.
WHY DO PEOPLE SAVE?
Why do people save part of their income instead of spending everything they earn? Economists have identified at least three broad reasons for saving. First, people save to meet certain long-term objectives, such as a comfortable retirement. By putting away part of their income during their working years, they can live better after retirement than they would if they had to rely solely on Social Security and their company pensions. Other long-term objectives might include college tuition for one’s children and the purchase of a new home or car. Since many of these needs occur at fairly predictable stages in one’s life, economists call this type of saving life-cycle saving.
A second reason to save is to protect oneself and family against unexpected setbacks—the loss of a job, for example, or a costly health problem. Personal financial advisors typically suggest that families maintain an emergency reserve (a “rainy-day fund”) equal to three to six months’ worth of income. Saving for protection against potential emergencies is called precautionary saving.
A third reason to save is to accumulate an estate to leave to one’s heirs, usually one’s children but possibly a favorite charity or other worthy cause. Saving for the purpose of leaving an inheritance, or bequest, is called bequest saving. Bequest saving is done primarily by people at the higher end of the income ladder. But because these people control a large share of the nation’s wealth, bequest saving is an important part of overall saving.
To be sure, people usually do not mentally separate their saving into these three categories; rather, all three reasons for saving motivate most savers to varying degrees. The Economic Naturalist 21.2 shows how the three reasons for saving can explain the high rate of household saving in China.
The Economic Naturalist 21.2
Why do Chinese households save so much?
A few years ago, economists estimated that Chinese households save more than 25 percent of their disposable income, an unusually high rate.1 Although some suggested that the Chinese “are known to be thrifty,” it is unlikely that cultural factors are a main reason for their propensity to save because the high saving rate is a relatively recent phenomenon. Chinese households saved well below 10 percent of their income until the late 1980s, and below 5 percent from the 1950s to the 1970s. Why do the Chinese save so much, then?
Among the reasons for saving we discussed, life-cycle and precautionary saving seem important in China. As we mentioned in Chapter 19, Economic Growth, Productivity, and Living Standards, the Chinese economy grew very quickly over the past several decades (Table 19.1 and Figure 19.1 in that chapter show the dramatic increase in China’s real GDP per person from 1990 to 2010). In a very rapidly growing economy, younger people in their working years are richer on average than people in their retirement years, as the young’s incomes are much higher than the incomes the retired had during their own working years. As a result, the saving of the young outweighs the dissaving of the retired. Moreover, China’s limited “social safety net”—its version of Social Security, Medicare, and other social insurance schemes (discussed in the next Economic Naturalist 21.3)—provides most people little in the way of retirement income or protection against health problems. That means that young households have to save both for their own retirement—life-cycle saving—and for unexpected expenses such as health-related ones—precautionary saving.
Another explanation for the high saving rates has to do with China’s financial system, which is closely controlled by the government and does not afford the average consumer much opportunity to borrow. This again translates both to higher life-cycle saving—because, for example, paying for a house or for education requires saving much of the cost in advance—and to higher precautionary saving—because households know that their ability to borrow in the case of an unexpected need would be limited.
If these explanations are correct, why is the high saving rate a relatively recent phenomenon? Starting in the late 1970s, China has undergone extensive economic reforms (recall our discussion of structural macroeconomics policies in previous chapters). These reforms have gradually turned China from a centrally planned economy to a more market-oriented economy. Before the reforms, households had less ability as well as less perceived need to engage in life-cycle and precautionary saving, because the central government controlled many aspects of their economic behavior and was considered responsible for providing for their needs. As institutions changed, households’ incentives changed, and they changed their saving behavior.
Note that the many uncertainties associated with changing economic institutions (indeed, with any big societal changes) could themselves provide another reason for relatively high precautionary saving. In particular, a transition to a more market-oriented economy could imply an increase in earnings uncertainty and unemployment risk. China’s transition also meant that the prices of housing, education, and other life-cycle expenditures increased, increasing the need for life-cycle saving.
Although most people are usually motivated to save for at least one of the three reasons we have discussed, the amount they choose to save may depend on the economic environment. One economic variable that is quite significant in saving decisions is the real interest rate.
SAVING AND THE REAL INTEREST RATE
Most people don’t save by putting cash in a mattress. Instead, they make financial investments that they hope will provide a good return on their saving. For example, a checking account may pay interest on the account balance. More sophisticated financial investments, such as government bonds or shares of stock in a corporation (see Chapter 23, Financial Markets and International Capital Flows), also pay returns in the form of interest payments, dividends, or capital gains. High returns are desirable, of course, because the higher the return, the faster one’s savings will grow.
The rate of return that is most relevant to saving decisions is the real interest rate, denoted r. Recall from Chapter 18, Measuring the Price Level and Inflation that the real interest rate is the rate at which the real purchasing power of a financial asset increases over time. The real interest rate equals the market, or nominal, interest rate (i) minus the inflation rate (π).
The real interest rate is relevant to savers because it is the “reward” for saving. Suppose you are thinking of increasing your saving by $1,000 this year, which you can do if you give up your habit of eating out once a week. If the real interest rate is 5 percent, then in a year your extra saving will give you extra purchasing power of $1,050, measured in today’s dollars. But if the real interest rate were 10 percent, your sacrifice of $1,000 this year would be rewarded by $1,100 in purchasing power next year. Obviously, all else being equal, you would be more willing to save today if you knew the reward next year would be greater. In either case the cost of the extra saving—giving up your weekly night out—is the same. But the benefit of the extra saving, in terms of increased purchasing power next year, is higher if the real interest rate is 10 percent rather than 5 percent.
Cost-Benefit
EXAMPLE 21.3Saving versus Consumption
By how much does a high saving rate enhance a family’s future living standard?
The Spends and the Thrifts are similar families, except that the Spends save 5 percent of their income each year and the Thrifts save 20 percent. The two families began to save in 1985 and plan to continue to save until their respective breadwinners retire in the year 2020. Both families earn $40,000 a year in real terms in the labor market, and both put their savings in a mutual fund that has yielded a real return of 8 percent per year, a return they expect to continue into the future. Compare the amount that the two families consume in each year from 1985 to 2020, and compare the families’ wealth at retirement.
In the first year, 1985, the Spends saved $2,000 (5 percent of their $40,000 income) and consumed $38,000 (95 percent of $40,000). The Thrifts saved $8,000 in 1985 (20 percent of $40,000) and hence consumed only $32,000 in that year, $6,000 less than the Spends. In 1986, the Thrifts’ income was $40,640, the extra $640 representing the 8 percent return on their $8,000 savings. The Spends saw their income grow by only $160 (8 percent of their savings of $2,000) in 1986. With an income of $40,640, the Thrifts consumed $32,512 in 1986 (80 percent of $40,640) compared to $38,152 (95 percent of $40, 1 60 ) for the Spends. The consumption gap between the two families, which started out at $6,000, thus fell to $5,640 after one year.
Because of the more rapid increase in the Thrifts’ wealth and hence interest income, each year the Thrifts’ income grew faster than the Spends’; each year the Thrifts continued to save 20 percent of their higher incomes compared to only 5 percent for the Spends. Figure 21.2 shows the paths followed by the consumption spending of the two families. You can see that the Thrifts’ consumption, though starting at a lower level, grows relatively more quickly. By 2000 the Thrifts had overtaken the Spends, and from that point onward, the amount by which the Thrifts outspent the Spends grew with each passing year. Even though the Spends continued to consume 95 percent of their income each year, their income grew so slowly that by 2005, they were consuming nearly $3,000 a year less than the Thrifts ( $41, 1 58 a year versus $43,957). And by the time the two families retire, in 2020, the Thrifts will be consuming more than $12,000 per year more than the Spends ($55,774 versus $43,698). Even more striking is the difference between the retirement nest eggs of the two families. Whereas the Spends will enter retirement with total accumulated savings of just over $77,000, the Thrifts will have more than $385,000, five times as much.
FIGURE 21.2 Consumption Trajectories of the Thrifts and the Spends.The figure shows consumption spending in each year by two families, the Thrifts and the Spends. Because the Thrifts save more than the Spends, their annual consumption spending rises relatively more quickly. By the time of retirement in the year 2020, the Thrifts are both consuming significantly more each year than the Spends and also have a retirement nest egg that is five times larger.
These dramatic differences illustrated in Example 21.3 depend in part on the assumption that the real rate of return is 8 percent—approximately the actual real return to mutual funds tracking the S&P 500 (with dividends reinvested) since 1985 but still a high rate of return from a historical perspective. On the other hand, the Spend family in our example actually saves more than typical U.S. households, many of which carry $5,000 or more in credit card debt at high rates of interest and have no significant savings at all. The point of the example, which remains valid under alternative assumptions about the real interest rate and saving rates, is that, because of the power of compound interest, a high rate of saving pays off handsomely in the long run.
While a higher real interest rate increases the reward for saving, which tends to strengthen people’s willingness to save, another force counteracts that extra incentive. Recall that a major reason for saving is to attain specific goals: a comfortable retirement, a college education, or a first home. If the goal is a specific amount—say, $25,000 for a down payment on a home—then a higher rate of return means that households can save less and still reach their goal, because funds that are put aside will grow more quickly. For example, to accumulate $25,000 at the end of five years, at a 5 percent interest rate a person would have to save about $4,309 per year. At a 10 percent interest rate, reaching the $25,000 goal would require saving only about $3,723 per year. To the extent that people are target savers who save to reach a specific goal, higher interest rates actually decrease the amount they need to save.
In sum, a higher real interest rate has both positive and negative effects on saving—a positive effect because it increases the reward for saving and a negative effect because it reduces the amount people need to save each year to reach a given target. Empirical evidence suggests that, in practice, higher real interest rates lead to modest increases in saving.
SAVING, SELF-CONTROL, AND DEMONSTRATION EFFECTS
The reasons for saving we just discussed are based on the notion that people are rational decision makers who will choose their saving rates to maximize their welfare over the long run. Yet many psychologists, and some economists, have argued instead that people’s saving behavior is based as much on psychological as on economic factors. For example, psychologists stress that many people lack the self-control to do what they know is in their own best interest. People smoke or eat greasy food, despite the known long-term health risks. Similarly, they may have good intentions about saving but lack the self-control to put aside as much as they ought to each month.
One way to strengthen self-control is to remove temptations from the immediate environment. A person who is trying to quit smoking will make a point of not having cigarettes in the house, and a person with a weight problem will avoid going to a bakery. Similarly, a person who is not saving enough might arrange to use a payroll savings plan, through which a predetermined amount is deducted from each paycheck and set aside in a special account from which withdrawals are not permitted until retirement. Making saving automatic and withdrawals difficult eliminates the temptation to spend all of current earnings or squander accumulated savings. Payroll savings plans have helped many people to increase the amount that they save for retirement or other purposes.
An implication of the self-control hypothesis is that consumer credit arrangements that make borrowing and spending easier may reduce the amount that people save. For example, in recent years banks sometimes encouraged people to borrow against the equity in their homes—that is, the value of the home less the value of the outstanding mortgage. Such financial innovations, by increasing the temptation to spend, may have reduced the household saving rate. The increased availability of credit cards with high borrowing limits is another temptation.
Downward pressure on the saving rate may also occur when additional spending by some consumers stimulates additional spending by others. Such demonstration effects arise when people use the spending of others as a yardstick by which to measure the adequacy of their own living standards. For example, a family in an upper-middle-class American suburb in which the average house has 3,000 square feet of living space might regard a 1,500-square-foot house as being uncomfortably small—too cramped, for example, to entertain friends in the manner to which community members have become accustomed. In contrast, a similar family living in a low-income neighborhood might find the very same house luxuriously large.
The implication of demonstration effects for saving is that families who live among others who consume more than they do may be strongly motivated to increase their own consumption spending. When satisfaction or social status depends in part on relative living standards, an upward spiral may result in which household spending is higher, and saving lower, than would be best for either the individual families involved or for the economy as a whole.
The Economic Naturalist 21.3
Why do U.S. households save so little?
Household saving in the United States, which has always been comparatively low, has fallen even further in the past decades (Figure 21.1 shows a dramatic 30-year fall from 13.1 percent in 1975 to 2.5 percent in 2005). Surveys show that a significant fraction of American households live from paycheck to paycheck with very little saving. Why do U.S. households save so little?
Economists do not agree on the reasons for low household saving in the United States, although many hypotheses have been suggested.
One possible reason for low saving is the availability of generous government assistance to the elderly. From a life-cycle perspective, an important motivation for saving is to provide for retirement. In general, the U.S. government provides a less comprehensive “social safety net” than other industrialized countries; that is, it offers relatively fewer programs to assist people in need. To the extent that the U.S. government does provide income support, however, it is heavily concentrated on the older segment of the population. Together the Social Security and Medicare programs, both of which are designed primarily to assist retired people, constitute a major share of the federal government’s expenditures. These programs have been very successful; indeed they have virtually wiped out poverty among the elderly. To the extent that Americans believe that the government will ensure them an adequate living standard in retirement, however, their incentive to save for the future is reduced.
Another important life-cycle objective is buying a home. We have seen that the Chinese must save a great deal to purchase a home because of high house prices and down payment requirements. The same is true in many other countries. But in the United States, with its highly developed financial system, people can buy homes with down payments of 15 percent or less of the purchase price. The ready availability of mortgages with low down payments reduces the need to save for the purchase of a home.
What about precautionary saving? Unlike Japan and Europe, which had to rebuild after World War II, and unlike China, which continued to suffer from major economic crises in the decades following the war, the United States has not known sustained economic hardship since the Great Depression of the 1930s (which fewer and fewer Americans are alive to remember). Perhaps the nation’s prosperous past has led Americans to be more confident about the future and hence less inclined to save for economic emergencies than other people, even though the United States does not offer the level of employment security found in Japan or in Europe.
U.S. household saving is not only low by international standards; it is declining. The good performance of the stock market in the 1990s along with continuing increases in the prices of family homes until the mid-2000s probably help to explain this savings decline (see Economic Naturalist 21.1). As long as Americans enjoy capital gains, they see their wealth increase almost without effort, and their incentive to save is reduced. Consistent with this explanation, U.S. household saving increased during and after the last recession as the value of stocks and homes declined, and started decreasing again in the last few years, as stocks and housing started rising again.
Psychological factors may also explain Americans’ saving behavior. For example, unlike in most countries, U.S. homeowners can easily borrow against their home equity. This ability, made possible by the highly developed U.S. financial markets, may exacerbate self-control problems by increasing the temptation to spend. Finally, demonstration effects may have depressed saving in recent decades. Chapter 20, The Labor Market: Workers, Wages, and Unemployment, discussed the phenomenon of increasing wage inequality, which has improved the relative position of more skilled and educated workers. Increased spending by households at the top of the earnings scale on houses, cars, and other consumption goods may have led those just below them to spend more as well, and so on. Middle-class families that were once content with medium-priced cars may now feel they need Volvos and BMWs to keep up with community standards. To the extent that demonstration effects lead families to spend beyond their means, they reduce their saving rate.
RECAP
WHY DO PEOPLE SAVE?
Motivations for saving include saving to meet long-term objectives, such as retirement (life-cycle saving), saving for emergencies (precautionary saving), and saving to leave an inheritance or bequest (bequest saving). The amount that people save also depends on macroeconomic factors, such as the real interest rate. A higher real interest rate stimulates saving by increasing the reward for saving, but it can also depress saving by making it easier for savers to reach a specific savings target. On net, a higher real interest rate appears to lead to modest increases in saving.
Psychological factors may also affect saving rates. If people have self-control problems, then financial arrangements (such as automatic payroll deductions) that make it more difficult to spend will increase their saving. People’s saving decisions may also be influenced by demonstration effects, as when people feel compelled to spend at the same rate as their neighbors, even though they may not be able to afford to do so.
NATIONAL SAVING AND ITS COMPONENTS
Thus far, we have been examining the concepts of saving and wealth from the individual’s perspective. But macroeconomists are interested primarily in saving and wealth for the country as a whole. In this section, we will study national saving, or the aggregate saving of the economy. National saving includes the saving of business firms and the government as well as that of households. Later in the chapter, we will examine the close link between national saving and the rate of capital formation in an economy.
THE MEASUREMENT OF NATIONAL SAVING
To define the saving rate of a country as a whole, we will start with a basic accounting identity that was introduced in Chapter 17, Measuring Economic Activity: GDP and Unemployment. According to this identity, for the economy as a whole, production (or income) must equal total expenditure. In symbols, the identity is
Y = C + I + G + NX,
where Y stands for either production or aggregate income (which must be equal), C equals consumption expenditure, I equals investment spending, G equals government purchases of goods and services, and NX equals net exports.
For now, let’s assume that net exports (NX) is equal to zero, which would be the case if a country did not trade at all with other countries or if its exports and imports were always balanced. (We discuss the case with NX being different from zero in Chapter 23, Financial Markets and International Capital Flows.) With net exports set at zero, the condition that output equals expenditure becomes
Y = C + I + G.
To determine how much saving is done by the nation as a whole, we can apply the general definition of saving. As for any other economic unit, a nation’s saving equals its current income less its spending on current needs. The current income of the country as a whole is its GDP, or Y—that is, the value of the final goods and services produced within the country’s borders during the year.
Identifying the part of total expenditure that corresponds to the nation’s spending on current needs is more difficult than identifying the nation’s income. The component of aggregate spending that is easiest to classify is investment spending I. We know that investment spending—the acquisition of new factories, equipment, and other capital goods, as well as residential construction—is done to expand the economy’s future productive capacity or provide more housing for the future, not to satisfy current needs. So investment spending clearly is not part of spending on current needs.
Deciding how much of consumption spending by households, C, and government purchases of goods and services, G, should be counted as spending on current needs is less straightforward. Certainly most consumption spending by households—on food, clothing, utilities, entertainment, and so on—is for current needs. But consumption spending also includes purchases of long-lived consumer durables, such as cars, furniture, and appliances. Consumer durables are only partially used up during the current year; they may continue to provide service, in fact, for years after their purchase. So household spending on consumer durables is a combination of spending on current needs and spending on future needs.
As with consumption spending, most government purchases of goods and services are intended to provide for current needs. However, like household purchases, a portion of government purchases is devoted to the acquisition or construction of long-lived capital goods, such as roads, bridges, schools, government buildings, and military hardware. And like consumer durables, these forms of public capital are only partially used up during the current year; most will provide useful services far into the future. So, like consumption spending, government purchases are in fact a mixture of spending on current needs and spending on future needs.
Although in reality not all spending by households and the government is for current needs, in practice, determining precisely how much of such spending is for current needs and how much is for future needs is extremely difficult. For this reason, for a long time U.S. government statistics treated all of both consumption expenditures (C) and government purchases (G) as spending on current needs.2 For simplicity’s sake, in this book we will follow the same practice. But keep in mind that because consumption spending and government purchases do in fact include some spending for future rather than current needs, treating all of C and G as spending on current needs will understate the true amount of national saving.
If we treat all consumption spending and government purchases as spending on current needs, then the nation’s saving is its income Y less its spending on current needs, C + G. So we can define national saving S as
S = Y − C − G.(21.1)
Figure 21.3 shows the U.S. national saving rate (national saving as a percentage of GDP) for the years 1960 through 2016. The U.S. national saving rate fell from 18–20 percent in the 1960s to around 12–14 percent in recent years. Like household saving, national saving declined over time, though by comparing Figures 21.1 and 21.3, you can see that the decline in national saving has been far more modest. Furthermore, unlike household saving, national saving recovered in the latter 1990s—indeed, in 2000 the national saving rate was almost 16 percent, very close to the rate in 1970. As we will see next, the reason for these differences between the behavior of national saving and household saving is that saving done by business firms and, more recently, by the government has been substantial.
FIGURE 21.3 U.S. National Saving Rate, 1960–2016.U.S. national saving fell from 18–20 percent of GDP in the 1960s to 12–14 percent in recent years.Source: Bureau of Economic Analysis, www.bea.gov.
PRIVATE AND PUBLIC COMPONENTS OF NATIONAL SAVING
To understand national saving better, we will divide it into two major components: private saving, which is saving done by households and businesses, and public saving, which is saving done by the government.
To see how national saving breaks down into public and private saving, we work with the definition of national saving, S = Y − C − G. To distinguish private-sector income from public-sector income, we must expand this equation to incorporate taxes as well as payments made by the government to the private sector. Government payments to the private sector include both transfer payments and interest paid to individuals and institutions that hold government bonds. Transfer payments are payments the government makes to the public for which it receives no current goods or services in return. Social Security benefits, welfare payments, farm support payments, and pensions to government workers are transfer payments.
Let T stand for taxes paid by the private sector to the government less transfer payments and interest payments made by the government to the private sector:
T = Total taxes − Transfer payments − Government interest payments.
Since T equals private-sector tax payments minus the various benefits and interest payments the private sector receives from the government, we can think of T as net taxes. If we add and then subtract T from the definition of national saving, S = Y − C − G, we get
S = Y − C − G + T − T.
Rearranging this equation and grouping terms, we obtain
S = (Y − T − C) + (T − G).(21.2)
This equation splits national saving S into two parts, private saving, or Y − T − C, and public saving, T − G.
Private saving, Y − T − C, is the saving of the private sector of the economy. Why is Y − T − C a reasonable definition of private saving? Remember that saving equals current income minus spending on current needs. The income of the private (nongovernmental) sector of the economy is the economy’s total income Y less net taxes paid to the government, T. The private sector’s spending on current needs is its consumption expenditures C. So private-sector saving, equal to private-sector income less spending on current needs, is Y − T − C. Letting Sprivate stand for private saving, we can write the definition of private saving as
SPrivate = Y − T − C.
Private saving can be further broken down into saving done by households and business firms. Household saving, also called personal saving, is saving done by families and individuals. Household saving corresponds to the familiar image of families putting aside part of their incomes each month, and it is the focus of much attention in the news media. But businesses are important savers as well—indeed business saving makes up the bulk of private saving in the United States. Businesses use the revenues from their sales to pay workers’ salaries and other operating costs, to pay taxes, and to provide dividends to their shareholders. The funds remaining after these payments have been made are equal to business saving. A business firm’s savings are available for the purchase of new capital equipment or the expansion of its operations. Alternatively, a business can put its savings in the bank for future use.
Public saving, T − G, is the saving of the government sector, including state and local governments as well as the federal government. Net taxes T are the income of the government. Government purchases G represent the government’s spending on current needs (remember that, for the sake of simplicity, we are ignoring the investment portion of government purchases). Thus T − G fits our definition of saving, in this case by the public sector. Letting Spublic stand for public saving, we can write out the definition of public saving as
Spublic = T − G.
Using Equation 21.2 and the definitions of private and public saving, we can rewrite national saving as
S = Sprivate + Spublic.(21.3)
This equation confirms that national saving is the sum of private saving and public saving. Since private saving can be broken down in turn into household and business saving, we see that national saving is made up of the saving of three groups: households, businesses, and the government.
PUBLIC SAVING AND THE GOVERNMENT BUDGET
Although the idea that households and businesses can save is familiar to most people, the fact that the government can also save is less widely understood. Public saving is closely linked to the government’s decisions about spending and taxing. Governments finance the bulk of their spending by taxing the private sector. If taxes and spending in a given year are equal, the government is said to have a balanced budget. If, in any given year, the government’s spending exceeds its tax collections, the difference is called the government budget deficit. If the government runs a deficit, it must make up the difference by borrowing from the public through issuance of government bonds. Algebraically, the government budget deficit can be written as G − T, or government purchases minus net tax collections.
In some years, the government may spend less than it collects in taxes. The excess of tax collections over government spending is called the government budget surplus. When a government has a surplus, it uses the extra funds to pay down its outstanding debt to the public. Algebraically, the government budget surplus may be written as T − G, or net tax collections less government purchases.
If the algebraic expression for the government budget surplus, T − G, looks familiar, that is because it is also the definition of public saving, as we saw earlier. Thus, public saving is identical to the government budget surplus. In other words, when the government collects more in taxes than it spends, public saving will be positive. When the government spends more than it collects in taxes so that it runs a deficit, public saving will be negative.
Example 21.4 illustrates the relationships among public saving, the government budget surplus, and national saving.
EXAMPLE 21.4Government Saving
How do we calculate government saving?
Following are data on U.S. government revenues and expenditures for 2000, in billions of dollars. Find (a) the federal government’s budget surplus or deficit, (b) the budget surplus or deficit of state and local governments, and (c) the contribution of the government sector to national saving.
The federal government’s receipts minus its expenditures were 2,063.2 − 1,906.6 = 156.6, so the federal government ran a budget surplus of $156.6 billion in 2000. State and local government receipts minus expenditures were 1,303.1 − 1,293.2 = 9.9, so state and local governments ran a collective budget surplus of $9.9 billion. The budget surplus of the entire government sector—that is, the federal surplus plus the state and local surplus—was 156.6 + 9.9 = 166.5, or $166.5 billion. So the contribution of the government sector to U.S. national saving in 2000 was $166.5 billion.
CONCEPT CHECK 21.4
Continuing Example 21.4, here are the analogous data on government revenues and expenditures for 2016, in billions of dollars. Again, find (a) the federal government’s budget surplus or deficit, (b) the budget surplus or deficit of state and local governments, and (c) the contribution of the government sector to national saving.
If you did Concept Check 21.4 correctly, you found that the government sector’s contribution to national saving in 2016 was negative. The reason is that the federal, state, and local governments taken together ran a budget deficit in that year, reducing national saving by the amount of the budget deficit.
Figure 21.3 showed the U.S. national saving rate since 1960. Figure 21.4 shows the behavior since 1960 of the three components of national saving: household saving, business saving, and public saving, each measured as a percentage of GDP. Note that business saving played a major role in national saving during these years, while the role of household saving was relatively modest. As we saw in Figure 21.1, household saving declined from the mid-1970s to the mid-2000s.
FIGURE 21.4 The Three Components of National Saving, 1960–2016.Of the three components of national saving, business saving is the most important.Source: Bureau of Economic Analysis, www.bea.gov.
The contribution of public saving has varied considerably over time. Until about 1970, the federal, state, and local governments typically ran a roughly balanced combined budget, making little contribution to national saving. But by the 1970s, public saving had turned negative, reflecting large budget deficits, particularly at the federal level. For the next two decades, the government was a net drain on national saving. During the late 1990s, government budgets moved closer to balance and, by the end of the decade, reached surplus, making a positive contribution to national saving. Government budgets dove again into deficits around the 2001 recession, and around the 2007–2009 recession, they reached deficits of historic scale. The relationship between government deficits and recessions was mentioned earlier in the text, and we will discuss it in more detail in future chapters.
IS LOW HOUSEHOLD SAVING A PROBLEM?
In the opening to this chapter, and again in Economic Naturalist 21.1 and 21.3, we mentioned that saving by U.S. households, never high by international standards, fell substantially during the past few decades (it rose during and following the 2007–2009 recession but then declined again and is still very low from a historical perspective). This decline in the household saving rate received much attention from the news media. Is the United States’ low household saving rate as much of a problem as the press suggests?
From a macroeconomic perspective, the problem posed by low household saving has probably been overstated. The key fact often overlooked in media reports is that national saving, not household saving, determines the capacity of an economy to invest in new capital goods and to achieve continued improvement in living standards. Although household saving is low, saving by business firms has been significant. Moreover, business saving has been increasing over the past few decades: as Figure 21.4 shows, business saving slowly increased from below 11 percent of GDP in the early 1960s to above 13 percent in each of the years since 2009. Overall, the decline in the U.S. national saving rate shown in Figure 21.3 has been less dramatic than the sharp decline in the household saving rate shown in Figure 21.1. Although U.S. national saving is somewhat low compared to that of other industrialized countries, it has been sufficient to allow the United States to become one of the world’s most productive economies.3
From a microeconomic perspective, however, the low household saving rate does signal a problem, which is the large and growing inequality in wealth among U.S. households. Saving patterns tend to increase this inequality since the economically better-off households tend not only to save more but, as business owners or shareholders, are also the ultimate beneficiaries of the saving done by businesses. Thus the wealth of these households, including both personal assets and the value of the businesses, is great. In contrast, lower-income families, many of whom save very little and do not own a business or shares in a corporation, have very little wealth—in many cases, their life savings are less than $5,000, or even negative (with debts and other liabilities that are greater than their assets). These households have little protection against setbacks such as chronic illness or job loss and must rely almost entirely on government support programs such as Social Security to fund their retirement. For this group, the low household saving rate is definitely a concern.
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NATIONAL SAVING AND ITS COMPONENTS
National saving, the saving of the nation as a whole, is defined by S = Y − C − G, where Y is GDP, C is consumption spending, and G is government purchases of goods and services. National saving is the sum of public saving and private saving: S = Sprivate + Spublic.
Private saving, the saving of the private sector, is defined by Sprivate = Y − T − C, where T is net tax payments. Private saving can be broken down further into household saving and business saving.
Public saving, the saving of the government, is defined by Spublic = T − G. Public saving equals the government budget surplus, T − G. When the government budget is in surplus, government saving is positive; when the government budget is in deficit, public saving is negative.
INVESTMENT AND CAPITAL FORMATION
From the point of view of the economy as a whole, the importance of national saving is that it provides the funds needed for investment. Investment—the creation of new capital goods and housing—is critical to increasing average labor productivity and improving standards of living.
What factors determine whether and how much firms choose to invest? Firms acquire new capital goods for the same reason they hire new workers: they expect that doing so will be profitable. We saw in Chapter 20, The Labor Market: Workers, Wages, and Unemployment that the profitability of employing an extra worker depends primarily on two factors: the cost of employing the worker and the value of the worker’s marginal product. In the same way, firms’ willingness to acquire new factories and machines depends on the expected cost of using them and the expected benefit, equal to the value of the marginal product that they will provide.
Cost-Benefit
EXAMPLE 21.5Investing in a Capital Good: Part 1
Should Larry buy a riding lawn mower?
Larry is thinking of going into the lawn care business. He can buy a $4,000 riding mower by taking out a loan at 6 percent annual interest. With this mower and his own labor, Larry can net $6,000 per summer, after deduction of costs such as gasoline and maintenance. Of the $6,000 net revenues, 20 percent must be paid to the government in taxes. Assume that Larry could earn $4,400 after taxes by working in an alternative job. Assume also that the lawn mower can always be resold for its original purchase price of $4,000. Should Larry buy the lawn mower?
To decide whether to invest in the capital good (the lawn mower), Larry should compare the financial benefits and costs. With the mower he can earn revenue of $6,000, net of gasoline and maintenance costs. However, 20 percent of that, or $1,200, must be paid in taxes, leaving Larry with $4,800. Larry could earn $4,400 after taxes by working at an alternative job, so the financial benefit to Larry of buying the mower is the difference between $4,800 and $4,400, or $400; $400 is the value of the marginal product of the lawn mower.
Since the mower does not lose value over time and since gasoline and maintenance costs have already been deducted, the only remaining cost Larry should take into account is the interest on the loan for the mower. Larry must pay 6 percent interest on $4,000, or $240 per year. Since this financial cost is less than the financial benefit of $400, the value of the mower’s marginal product, Larry should buy the mower.
Larry’s decision might change if the costs and benefits of his investment in the mower change, as Example 21.6 shows.
EXAMPLE 21.6Investing in a Capital Good: Part 2
How do changes in the costs and benefits affect Larry’s decision?
With all other assumptions the same as in Example 21.5, decide whether Larry should buy the mower:
a. If the interest rate is 12 percent rather than 6 percent.
b. If the purchase price of the mower is $7,000 rather than $4,000.
c. If the tax rate on Larry’s net revenues is 25 percent rather than 20 percent.
d. If the mower is less efficient than Larry originally thought so that his net revenues will be $5,500 rather than $6,000.
In each case, Larry must compare the financial costs and benefits of buying the mower.
a. If the interest rate is 12 percent, then the interest cost will be 12 percent of $4,000, or $480, which exceeds the value of the mower’s marginal product ($400). Larry should not buy the mower.
b. If the cost of the mower is $7,000, then Larry must borrow $7,000 instead of $4,000. At 6 percent interest, his interest cost will be $420—too high to justify the purchase, since the value of the mower’s marginal product is $400.
c. If the tax rate on net revenues is 25 percent, then Larry must pay 25 percent of his $6,000 net revenues, or $1,500, in taxes. After taxes, his revenues from mowing will be $4,500, which is only $100 more than he could make working at an alternative job. Furthermore, the $100 will not cover the $240 in interest that Larry would have to pay. So again, Larry should not buy the mower.
d. If the mower is less efficient than originally expected so that Larry can earn net revenues of only $5,500, Larry will be left with only $4,400 after taxes—the same amount he could earn by working at another job. So in this case, the value of the mower’s marginal product is zero. At any interest rate greater than zero, Larry should not buy the mower.
CONCEPT CHECK 21.5
Repeat Example 21.5, but assume that, over the course of the year, wear and tear reduces the resale value of the lawn mower from $4,000 to $3,800. Should Larry buy the mower?
The examples involving Larry and the lawn mower illustrate the main factors firms must consider when deciding whether to invest in new capital goods. On the cost side, two important factors are the price of capital goods and the real interest rate. Clearly, the more expensive new capital goods are, the more reluctant firms will be to invest in them. Buying the mower was profitable for Larry when its price was $4,000, but not when its price was $7,000.
Why is the real interest rate an important factor in investment decisions? The most straightforward case is when a firm has to borrow (as Larry did) to purchase its new capital. The real interest rate then determines the real cost to the firm of paying back its debt. Since financing costs are a major part of the total cost of owning and operating a piece of capital, much as mortgage payments are a major part of the cost of owning a home, increases in the real interest rate make the purchase of capital goods less attractive to firms, all else being equal.
Even if a firm does not need to borrow to buy new capital—say, because it has accumulated enough profits to buy the capital outright—the real interest rate remains an important determinant of the desirability of an investment. If a firm does not use its profits to acquire new capital, most likely it will use those profits to acquire financial assets such as bonds, which will earn the firm the real rate of interest. If the firm uses its profits to buy capital rather than to purchase a bond, it forgoes the opportunity to earn the real rate of interest on its funds. Thus the real rate of interest measures the opportunity cost of a capital investment. Since an increase in the real interest rate raises the opportunity cost of investing in new capital, it lowers the willingness of firms to invest, even if they do not literally need to borrow to finance new machines or equipment.
Increasing Opportunity Cost
On the benefit side, the key factor in determining business investment is the value of the marginal product of the new capital, which should be calculated net of both operating and maintenance expenses and taxes paid on the revenues the capital generates. The value of the marginal product is affected by several factors. For example, a technological advance that allows a piece of capital to produce more goods and services would increase the value of its marginal product, as would lower taxes on the revenues produced by the new capital. An increase in the relative price of the good or service that the capital is used to produce will also increase the value of the marginal product and, hence, the desirability of the investment. For example, if the going price for lawn-mowing services were to rise, then all else being equal, investing in the mower would become more profitable for Larry.
The Economic Naturalist 21.4
Why has investment in computers increased so much in recent decades?
Since about 1980, investment in new computer systems by U.S. firms has risen sharply (see Figure 21.5). Purchases of new computers and software by firms now exceed 2.2 percent of GDP and amount to about 18 percent of all private nonresidential investment. Why has investment in computers increased so much?
FIGURE 21.5 Investment in Computers and Software, 1970–2016.Investment in computer equipment and software since 1970 shown as a percentage of private nonresidential investment. Note how computer investments by U.S. firms started rising significantly as a percentage of private investment in 1980, but have since started to decline.Source: Bureau of Economic Analysis, www.bea.gov.
Investment in computers has increased by much more than other types of investment. Hence, the factors that affect all types of investment (such as the real interest rate and the tax rate) are not likely to be responsible for the boom. The two main causes of increased investment in computers appear to be the declining price of computing power and the increase in the value of the marginal product of computers. In recent years, the price of computing power has fallen at a precipitous rate. An industry rule of thumb is that the amount of computing power that is obtainable at a given price doubles every 18 months. As the price of computing power falls, an investment in computers becomes more and more likely to pass the cost-benefit test.
Cost-Benefit
On the benefit side, for some years after the beginning of the computer boom economists were unable to associate the technology with significant productivity gains. Defenders of investment in computer systems argued that the improvements in goods and services computers create are particularly hard to measure. How does one quantify the value to consumers of 24-hour-a-day access to cash or of the ability to make airline reservations online? Critics responded that the expected benefits of the computer revolution may have proved illusory because of problems such as user-unfriendly software and poor technical training. However, U.S. productivity did increase noticeably in the years following the beginning of widespread use of the Internet, and many people are now crediting the improvement to investment in computers, software, and Internet-related technologies.
RECAP
FACTORS THAT AFFECT INVESTMENT
Any of the following factors will increase the willingness of firms to invest in new capital:
1. A decline in the price of new capital goods.
2. A decline in the real interest rate.
3. Technological improvement that raises the marginal product of capital.
4. Lower taxes on the revenues generated by capital.
5. A higher relative price for the firm’s output.
SAVING, INVESTMENT, AND FINANCIAL MARKETS
Saving and investment are determined by different forces. Ultimately, though, in an economy without international borrowing and lending, national saving must equal investment. The supply of savings (by households, firms, and the government) and the demand for savings (by firms that want to purchase or construct new capital) are equalized through the workings of financial markets. Figure 21.6 illustrates this process. Quantities of national saving and investment are measured on the horizontal axis; the real interest rate is shown on the vertical axis. As we will see, in the market for saving, the real interest rate functions as the “price.”
FIGURE 21.6 The Supply of and Demand for Savings.Savings are supplied by households, firms, and the government and demanded by borrowers wishing to invest in new capital goods. The supply of saving (S) increases with the real interest rate, and the demand for saving by investors (I) decreases with the real interest rate. In financial market equilibrium, the real interest rate takes the value that equates the quantity of saving supplied and demanded.
In Figure 21.6, the supply of savings is shown by the upward-sloping curve marked S. This curve shows the quantity of national saving that households, firms, and the government are willing to supply at each value of the real interest rate. The saving curve is upward-sloping because empirical evidence suggests that increases in the real interest rate stimulate saving. The demand for saving is given by the downward-sloping curve marked I. This curve shows the quantity of investment in new capital that firms would choose and hence the amount they would need to borrow in financial markets, at each value of the real interest rate. Because higher real interest rates raise the cost of borrowing and reduce firms’ willingness to invest, the demand for saving curve is downward-sloping.
Putting aside the possibility of borrowing from foreigners (discussed in Chapter 23, Financial Markets and International Capital Flows), a country can invest only those resources that its savers make available. In equilibrium, then, desired investment (the demand for savings) and desired national saving (the supply of savings) must be equal. As Figure 21.6 suggests, desired saving is equated with desired investment through adjustments in the real interest rate, which functions as the “price” of saving. The movements of the real interest rate clear the market for savings in much the same way that the price of apples clears the market for apples. In Figure 21.6, the real interest rate that clears the market for saving is r, the real interest rate that corresponds to the intersection of the supply and demand curves.
The forces that push the real interest rate toward its equilibrium level are similar to the forces that lead to equilibrium in any other supply and demand situation. Suppose, for example, that the real interest rate exceeded r. At a higher real interest rate, savers would provide more funds than firms would want to invest. As lenders (savers) competed among themselves to attract borrowers (investors), the real interest rate would be bid down. The real interest rate would fall until it equaled r, the only interest rate at which both borrowers and lenders are satisfied, and no opportunities are left unexploited in the financial market. The Equilibrium Principle thus holds for this market. What would happen if the real interest rate were lower than r?
Equilibrium
Changes in factors other than the real interest rate that affect the supply of or demand for saving will shift the curves, leading to a new equilibrium in the financial market. Changes in the real interest rate cannot shift the supply or demand curves, just as a change in the price of apples cannot shift the supply or demand for apples, because the effects of the real interest rate on savings are already incorporated in the slopes of the curves. A few examples will illustrate the use of the supply and demand model of financial markets.
EXAMPLE 21.7The Effects of New Technology
How does the introduction of new technologies affect saving, investment, and the real interest rate?
The late 1990s saw the introduction and application of exciting new technologies, ranging from the Internet to new applications of genetics. A number of these technologies appeared at the time to have great commercial potential. How does the introduction of new technologies affect saving, investment, and the real interest rate?
The introduction of any new technology with the potential for commercial application creates profit opportunities for those who can bring the fruits of the technology to the public. In economists’ language, the technical breakthrough raises the marginal product of new capital. Figure 21.7 shows the effects of a technological breakthrough, with a resulting increase in the marginal product of capital. At any given real interest rate, an increase in the marginal product of capital makes firms more eager to invest. Thus, the advent of the new technology causes the demand for saving to shift upward and to the right, from I to I′.
FIGURE 21.7 The Effects of a New Technology on National Saving and Investment.A technological breakthrough raises the marginal product of new capital goods, increasing desired investment and the demand for savings. The real interest rate rises, as do national saving and investment.
At the new equilibrium point F, investment and national saving are higher than before, as is the real interest rate, which rises from r to r′. The rise in the real interest rate reflects the increased demand for funds by investors as they race to apply the new technologies. Because of the incentive of higher real returns, saving increases as well. Indeed, the real interest rate in the United States was relatively high in the late 1990s (see Figure 18.2), as was the rate of investment, reflecting the opportunities created by new technologies.
Example 21.8 examines the effect of changing fiscal policies on the market for saving.
EXAMPLE 21.8The Effects of Changing Fiscal Policies
How does an increase in the government budget deficit affect saving, investment, and the real interest rate?
Suppose the government increases its spending without raising taxes, thereby increasing its budget deficit (or reducing its budget surplus). How will this decision affect national saving, investment, and the real interest rate?
National saving includes both private saving (saving by households and businesses) and public saving, which is equivalent to the government budget surplus. An increase in the government budget deficit (or a decline in the surplus) reduces public saving. Assuming that private saving does not change, the reduction in public saving will reduce national saving as well.
Figure 21.8 shows the effect of the increased government budget deficit on the market for saving and investment. At any real interest rate, a larger deficit reduces national saving, causing the saving curve to shift to the left, from S to S′. At the new equilibrium point F, the real interest rate is higher at r′, and both national saving and investment are lower. In economic terms, the government has dipped further into the pool of private savings to borrow the funds to finance its budget deficit. The government’s extra borrowing forces investors to compete for a smaller quantity of available saving, driving up the real interest rate. The higher real interest rate makes investment less attractive, ensuring that investment will decrease along with national saving.
FIGURE 21.8 The Effects of an Increase in the Government Budget Deficit on National Saving and Investment.An increase in the government budget deficit reduces the supply of saving, raising the real interest rate and lowering investment. The tendency of increased government deficits to reduce investment in new capital is called crowding out.
The tendency of government budget deficits to reduce investment spending is called crowding out. Reduced investment spending implies slower capital formation, and thus lower economic growth. This adverse effect of budget deficits on economic growth is probably the most important cost of deficits, and a major reason why economists advise governments to minimize their deficits.
CONCEPT CHECK 21.6
Suppose the general public becomes more “grasshopper-like” and less “ant-like” in their saving decisions, becoming less concerned about saving for the future. How will the change in public attitudes affect the country’s rate of capital formation and economic growth?
At the national level, high saving rates lead to greater investment in new capital goods and thus higher standards of living. At the individual or family level, a high saving rate promotes the accumulation of wealth and the achievement of economic security. In this chapter we have studied some of the factors that underlie saving and investment decisions. The next chapter will look more closely at how savers hold their wealth and at how the financial system allocates the pool of available savings to the most productive investment projects.
RECAP
SAVING, INVESTMENT, AND FINANCIAL MARKETS
· Financial markets bring together the suppliers of savings (households, firms, and the government) and demanders for savings (firms that want to purchase or construct new capital).
· Putting aside the possibility of borrowing from foreigners (discussed in Chapter 23, Financial Markets and International Capital Flows), a country can invest only those resources that its savers make available. In equilibrium, then, desired investment (the demand for savings) must equal desired national saving (the supply of savings).
· In equilibrium, supply and demand are equated through adjustments in the real interest rate, which functions as the “price” of saving.
· Changes in factors other than the real interest rate that affect the supply of or demand for saving will shift the supply and demand curves, leading to a new equilibrium in the financial market.
· For example, any of the following factors will increase the willingness of firms to invest in new capital, and will therefore shift the demand curve outward:
1. A decline in the price of new capital goods.
2. Technological improvement that raises the marginal product of capital.
3. Lower taxes on the revenues generated by capital.
4. A higher relative price for the firm’s output.
SUMMARY
· In general, saving equals current income minus spending on current needs; the saving rate is the percentage of income that is saved. Wealth, or net worth, equals the market value of assets (real or financial items of value) minus liabilities (debts). Saving is a flow, being measured in dollars per unit of time; wealth is a stock, measured in dollars at a point in time. As the amount of water in a bathtub changes according to the rate at which water flows in, the stock of wealth increases at the saving rate. Wealth also increases if the value of existing assets rises (capital gains) and decreases if the value of existing assets falls (capital losses). (LO1)
· Individuals and households save for a variety of reasons, including life-cycle objectives, such as saving for retirement or a new home; the need to be prepared for an emergency (precautionary saving); and the desire to leave an inheritance (bequest saving). The amount people save is also affected by the real interest rate, which is the “reward” for saving. Evidence suggests that higher real interest rates lead to modest increases in saving. Saving can also be affected by psychological factors, such as the degree of self-control and the desire to consume at the level of one’s neighbors (demonstration effects). (LO2)
· The saving of an entire country is national saving S. National saving is defined by S = Y − C − G, where Y represents total output or income, C equals consumption spending, and G equals government purchases of goods and services. National saving can be broken up into private saving, or Y − T − C, and public saving, or T − G, where T stands for taxes paid to the government less transfer payments and interest paid by the government to the private sector. Private saving can be further broken down into household saving and business saving. In the United States, the bulk of private saving is done by businesses. (LO3)
· Public saving is equivalent to the government budget surplus, T − G; if the government runs a budget deficit, then public saving is negative. The U.S. national saving rate is low relative to other industrialized countries, but it is higher than U.S. household saving, and it declined less over the past few decades. (LO3)
· Investment is the purchase or construction of new capital goods, including housing. Firms will invest in new capital goods if the benefits of doing so outweigh the costs. Two factors that determine the cost of investment are the price of new capital goods and the real interest rate. The higher the real interest rate, the more expensive it is to borrow, and the less likely firms are to invest. The benefit of investment is the value of the marginal product of new capital, which depends on factors such as the productivity of new capital goods, the taxes levied on the revenues they generate, and the relative price of the firm’s output. (LO4)
· In the absence of international borrowing or lending, the supply of and demand for national saving must be equal. The supply of national saving depends on the saving decisions of households and businesses and the fiscal policies of the government (which determine public saving). The demand for saving is the amount business firms want to invest in new capital. The real interest rate, which is the “price” of borrowed funds, changes to equate the supply of and demand for national saving. Factors that affect the supply of or demand for saving will change saving, investment, and the equilibrium real interest rate. For example, an increase in the government budget deficit will reduce national saving and investment and raise the equilibrium real interest rate. The tendency of government budget deficits to reduce investment is called crowding out. (LO5)
KEY TERMS
assets
balance sheet
bequest saving
capital gains
capital losses
crowding out
flow
government budget deficit
government budget surplus
liabilities
life-cycle saving
market interest rate
national saving
net worth
precautionary saving
private saving
public saving
saving
saving rate
stock
transfer payments
wealth
REVIEW QUESTIONS
1. Explain the relationship between saving and wealth, using the concepts of flows and stocks. Is saving the only means by which wealth can increase? Explain. (LO1)
2. Give three basic motivations for saving. Illustrate each with an example. What other factors would psychologists cite as being possibly important for saving? (LO2)
3. Define national saving, relating your definition to the general concept of saving. Why does the standard U.S. definition of national saving potentially understate the true amount of saving being done in the economy? (LO3)
4. Household saving rates in the U.S. are very low. Is this fact a problem for the U.S. economy? Why or why not? (LO3)
5. Why do increases in real interest rates reduce the quantity of saving demanded? (Hint: Who are the “demanders” of saving?) (LO4, LO5)
6. Name one factor that could increase the supply of saving and one that could increase the demand for saving. Show the effects of each on saving, investment, and the real interest rate. (LO5)
PROBLEMS
1. Corey has a mountain bike worth $300, credit card debt of $150, $200 in cash, a Sandy Koufax baseball card worth $400, $1,200 in a checking account, and an electric bill due for $250. (LO1)
a. Construct Corey’s balance sheet and calculate his net worth. For each remaining part, explain how the event affects Corey’s assets, liabilities, and wealth.
b. Corey goes to a baseball card convention and finds out that his baseball card is a worthless forgery.
c. Corey uses $150 from his paycheck to pay off his credit card balance. The remainder of his earnings is spent.
d. Corey writes a $150 check on his checking account to pay off his credit card balance.
Of the events in parts b–d, which, if any, corresponds to saving on Corey’s part?
2. State whether each of the following is a stock or a flow, and explain. (LO1)
a. The gross domestic product.
b. National saving.
c. The value of the U.S. housing stock on January 1, 2017.
d. The amount of U.S. currency in circulation as of this morning.
e. The government budget deficit.
f. The quantity of outstanding government debt on January 1, 2017.
3. Ellie and Vince are a married couple, both with college degrees and jobs. How would you expect each of the following events to affect the amount they save each month? Explain your answers in terms of the basic motivations for saving. (LO2)
a. Ellie learns she is pregnant.
b. Vince reads in the paper about possible layoffs in his industry.
c. Vince had hoped that his parents would lend financial assistance toward the couple’s planned purchase of a house, but he learns that they can’t afford it.
d. Ellie announces that she would like to go to law school in the next few years.
e. A boom in the stock market greatly increases the value of the couple’s retirement funds.
f. Vince and Ellie agree that they would like to leave a substantial amount to local charities in their wills.
4. Individual retirement accounts, or IRAs, were established by the U.S. government to encourage saving. An individual who deposits part of current earnings in an IRA does not have to pay income taxes on the earnings deposited, nor are any income taxes charged on the interest earned by the funds in the IRA. However, when the funds are withdrawn from the IRA, the full amount withdrawn is treated as income and is taxed at the individual’s current income tax rate. In contrast, an individual depositing in a non-IRA account has to pay income taxes on the funds deposited and on interest earned in each year but does not have to pay taxes on withdrawals from the account. Another feature of IRAs that is different from a standard saving account is that funds deposited in an IRA cannot be withdrawn prior to retirement, except upon payment of a substantial penalty. (LO2)
a. Sarah, who is five years from retirement, receives a $10,000 bonus at work. She is trying to decide whether to save this extra income in an IRA account or in a regular savings account. Both accounts earn 5 percent nominal interest, and Sarah is in the 30 percent tax bracket in every year (including her retirement year). Compare the amounts that Sarah will have in five years under each of the two saving strategies, net of all taxes. Is the IRA a good deal for Sarah?
b. Would you expect the availability of IRAs to increase the amount that households save? Discuss in light of (1) the response of saving to changes in the real interest rate and (2) psychological theories of saving.
5. In each part that follows, use the economic data given to find national saving, private saving, public saving, and the national saving rate. (LO3)
a. Household saving = 200 Business saving = 400
Government purchases of goods and services = 100
Government transfers and interest payments = 100
Tax collections = 150 GDP = 2,200
b. GDP = 6,000 Tax collections = 1,200
Government transfers and interest payments = 400 Consumption expenditures = 4,500
Government budget surplus = 100
c. Consumption expenditures = 4,000
Investment = 1,000
Government purchases = 1,000 Net exports = 0
Tax collections = 1,500
Government transfers and interest payments = 500
6. Ellie and Vince are trying to decide whether to purchase a new home. The house they want is priced at $200,000. Annual expenses such as maintenance, taxes, and insurance equal 4 percent of the home’s value. If properly maintained, the house’s real value is not expected to change. The real interest rate in the economy is 6 percent, and Ellie and Vince can qualify to borrow the full amount of the purchase price (for simplicity, assume no down payment) at that rate. Ignore the fact that mortgage interest payments are tax-deductible in the United States. (LO4)
a. Ellie and Vince would be willing to pay $1,500 monthly rent to live in a house of the same quality as the one they are thinking about purchasing. Should they buy the house?
b. Does the answer to part a change if they are willing to pay $2,000 monthly rent?
c. Does the answer to part a change if the real interest rate is 4 percent instead of 6 percent?
d. Does the answer to part a change if the developer offers to sell Ellie and Vince the house for $150,000?
e. Why do home-building companies dislike high interest rates?
7. The builder of a new movie theater complex is trying to decide how many screens she wants. Below are her estimates of the number of patrons the complex will attract each year, depending on the number of screens available. (LO4)
After paying the movie distributors and meeting all other noninterest expenses, the owner expects to net $2.00 per ticket sold. Construction costs are $1,000,000 per screen.
a. Make a table showing the value of marginal product for each screen from the first through the fifth. What property is illustrated by the behavior of marginal products?
How many screens will be built if the real interest rate is:
b. 5.5 percent?
c. 7.5 percent?
d. 10 percent?
e. If the real interest rate is 5.5 percent, how far would construction costs have to fall before the builder would be willing to build a five-screen complex?
8. For each of the following scenarios, use supply and demand analysis to predict the resulting changes in the real interest rate, national saving, and investment. Show all your diagrams. (LO5)
a. The legislature passes a 10 percent investment tax credit. Under this program, for every $100 that a firm spends on new capital equipment, it receives an extra $10 in tax refunds from the government.
b. A reduction in military spending moves the government’s budget from deficit into surplus.
c. A new generation of computer-controlled machines becomes available. These machines produce manufactured goods much more quickly and with fewer defects.
d. The government raises its tax on corporate profits. Other tax changes are also made, such that the government’s deficit remains unchanged.
e. Concerns about job security raise precautionary saving.
f. New environmental regulations increase firms’ costs of operating capital.
ANSWERS TO CONCEPT CHECKS
21.1If Consuelo’s student loan were for $6,500 instead of $3,000, her liabilities would be $6,750 (the student loan plus the credit card balance) instead of $3,250. The value of her assets, $6,280, is unchanged. In this case Consuelo’s wealth is negative, since assets of $6,280 less liabilities of $6,750 equals −$470. Negative wealth or net worth means one owes more than one owns. (LO1)
21.2If water is being drained from the tub, the flow is negative, equal to −3 gallons per minute. There are 37 gallons in the tub at 7:16 p.m. and 34 gallons at 7:17 p.m. The rate of change of the stock is −3 gallons per minute, which is the same as the flow. (LO1)
21.3
a. Consuelo has set aside her usual $20, but she has also incurred a new liability of $50. So her net saving for the week is minus $30. Since her assets (her checking account) have increased by $20 but her liabilities (her credit card balance) have increased by $50, her wealth has also declined by $30. (LO1)
b. In paying off her credit card bill, Consuelo reduces her assets by $300 by drawing down her checking account and reduces her liabilities by the same amount by reducing her credit card balance to zero. Thus there is no change in her wealth. There is also no change in her saving (note that Consuelo’s income and spending on current needs have not changed).
c. The increase in the value of Consuelo’s car raises her assets by $500. So her wealth also rises by $500. Changes in the value of existing assets are not treated as part of saving, however, so her saving is unchanged.
d. The decline in the value of Consuelo’s furniture is a capital loss of $300. Her assets and wealth fall by $300. Her saving is unchanged.
21.4The federal government had expenditures greater than receipts, so it ran a deficit. The federal deficit equaled expenditures of 4,149.4 minus revenues of 3,452.1, or $697.3 billion. Equivalently, the federal budget surplus was minus $697.3 billion. State and local governments had a deficit equal to expenditures of 2,583.7 minus receipts of 2,416.3, or $167.4 billion. The entire government sector ran a deficit of 697.3 + 167.4 = $864.7 billion. (You can also find this answer by adding federal to state and local expenditures and comparing this number to the sum of federal and state-local receipts.) The government sector’s contribution to national saving in 2016 was negative, equal to −$864.7 billion. (LO3)
21.5The loss of value of $200 over the year is another financial cost of owning the mower, which Larry should take into account in making his decision. His total cost is now $240 in interest costs plus $200 in anticipated loss of value of the mower (known as depreciation), or $440. This exceeds the value of marginal product, $400, and so now Larry should not buy the mower. (LO4)
21.6Household saving is part of national saving. A decline in household saving, and hence national saving, at any given real interest rate shifts the saving supply curve to the left. The results are as in Figure 21.8. The real interest rate rises and the equilibrium values of national saving and investment fall. Lower investment is the same as a lower rate of capital formation, which would be expected to slow economic growth. (LO5)
1For these estimates, and for detail on some of the explanations and evidence we discuss here, see, for example, Dennis Tao Yang, Junsen Zhang, and Shaojie Zhou, “Why Are Saving Rates So High in China?” NBER Working Paper 16771, February 2011.
2Nowadays, the official data distinguish investment in public capital from the rest of government purchases.
3In addition to its domestic saving, the U.S. attracts savings from abroad, as we discuss in Chapter 23, Financial Markets and International Capital Flows.