Week 2 Saving and Wealth

Lectures 3 & 4

Reference: Bernanke, Olekalns and Frank - Chapter 2 Key Issues Definition and Measures of Saving Saving and Wealth Motives for Saving Investment and Capital Accumulation Saving, Investment and the Real Interest Rate

Saving Saving = current income current spending Saving rate =

Saving Income

Saving is a flow variable

If saving is positive then assets are being accumulated

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

Fluctuations in the market value of assets capital gains or capital losses have can have an important effect on net wealth Change in Wealth = Saving + Capital gains Capital losses Change in Wealth = W = W W(-1) W = W(-1) + S + Net Capital Gains
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Assets, liabilities and wealth are stock variables Wealth Net Wealth = Value of Assets Value of Liabilities Balance Sheet Assets $ Liabilities $ House (m.v.) 700,000 Mortgage 450,000 Car (m.v.) 10,000 Credit Card 3,500 Bank Account 3,500 Shares (m.v.) 25,000 Furniture (m.v.) 15,000 Total 753,500 Total 453,500
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Net Wealth = 300,000 Asset Pricing

m.v. = market value

How can we determine the price of a financial asset? Characteristics of Financial Assets have monetary payoffs ($X) payoffs arrive in the future (need to discount) payoffs can be uncertain (risky)

Simple Example: What is the value today of a (certain) $100 in the next period? Present-Value Formula Suppose the interest rate (r) is 5 percent (0.05)
PV = 100 = $95.24 (1 + 0.05)

Some Notation PV = Price of asset (today)

100 = payoff of asset

1 (1 + 0.05)

= discount factor
X 1 P= = X (1 + r ) 1 + r

Asset Pricing Formula

Price of Asset (today) = Discount Factor Payoff (tomorrow)

With Uncertainty Price of Asset (today) =

Expected Value of [Discount Factor Payoff (tomorrow)] Very general formula, but can be specialized to particular assets. Example: Share Price Assume (for simplicity) complete certainty Payoff for a share

Pays a dividend

D1

in the next period

Resale price in the next period is Payoff =

X 1 = P1 + D1

P1

Discount Factor Let r be the certain return on an alternative asset (e.g. a bank deposit)
P0 = P1 + D1 1+ r

Simple model for share price

Complications Payoff on share is uncertain What is the correct discount factor? Different asset pricing models use different discount factors. Motives For Saving 1. Life-Cycle Saving Typically people only work for some fraction of their lifetime, e.g. might work from age 20 to 60.

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Consume over your entire lifetime, e.g. might expect to live to 80. Save during your working life to provide for consumption during retirement. Households might also save for other costly items such as: House deposit Education expenses 2. Precautionary Saving
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Saving can be used as a form of insurance against unexpected declines in income or unexpected increases in consumption, e.g. temporary unemployment, medical expenses 3. Bequest Saving People save to leave a bequest or inheritance for their heirs and dependents

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Saving and the Real Interest Rate We expect the level of saving will increase with higher real returns to various assets.

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

S(r) r

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Saving Psychology and Behavioral Motives for Saving Standard macroeconomic model assumes that individuals and households choose a level of saving that maximizes their long-run welfare
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In reality people may lack sufficient self-control or willpower to undertake an optimal level of saving. The consumption benefits of saving arise far into the future, but costs in terms of forgone consumption are immediate. Factors that tend to reduce saving Availability of consumer credit, e.g. home equity loans

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 Demonstration effects. High consumption levels of our neighbors may influence us to consume more and save less Government provision of retirement benefits may lead to less private saving for retirement. Reducing ones own saving in response to government retirement benefits may be rational behavior If people cannot make rational savings decisions what can be done?

Compulsory superannuation saving.

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Hard to justify this policy of compulsory saving if we believe that individuals make fully rational saving decisions. Compulsory saving schemes will only increase total saving if individuals do not reduce their voluntary saving by an equal amount in response. Household saving ratio for Australia

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S/Y 0.000 0.050 0.100 0.150 0.200 -0.100 Sep-59 Sep-62 Sep-65 Sep-68 Sep-71 Sep-74 Sep-77 Sep-80 Sep-83 Sep-86 Sep-89 Sep-92 Sep-95 Sep-98 Sep-01 Sep-04 Sep-07 -0.050

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

National Accounting Identity

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Y = C + I + G + NX Assume NX=0 Y=C+I+G Saving = Current income current spending S=YCG We exclude I because by definition it is spending that provides for future needs not current ones. Durable Goods
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In reality not all of C and G are for immediate needs. Consumer durables (e.g. cars, furniture, appliances) provide a flow of consumption services over a period of time. Government purchases of durable goods (e.g. roads, bridges, schools, other infrastructure) will provide a future flow of services. Known as public capital. Private and Public Components of Saving
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Private Saving Households Business Public Saving Government

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

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

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2007 2005 2003

Government Budget Balance (cash balance)

2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 3 2 1 0 -1 -2 -3 -4 -5

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% of GDP

Investment and Capital Formation National saving provides the resources for investment. Investment is the purchase of new capital goods. Influences on the level of Investment Cost of capital Should Tiger Airlines buy an additional plane? Costs vs. Benefits
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3 Components to Cost of Capital (The following is more technical than in BOF) 1. Suppose Tiger Airlines have to borrow the funds to buy the new plane at the nominal interest rate = i The dollar price/cost of the new plane =
PK

(Note: even if they used retained earnings there would be an opportunity cost = i ) 2. Physical depreciation rate on plane =

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3. Over time the price of the plane may rise or fall (capital gain or capital loss) = PK Net cost of owning a plane for one year. Cost of capital = price of capital (begin year) + interest cost - price of (depreciated) capital (end year) Cost of capital =
PK + iPK (1 )[ PK + PK ]

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

PK PK
PK + iPK (1 )[ PK + PK ]

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

is small

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Cost of capital = rate of inflation

PK PK (i + ) PK

Finally let the price of capital goods rise at the general

PK = PK

Cost of capital = or since

r = i

PK (i + )

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Cost of capital = Summary

PK (r + )

Model suggests that two important influences on Tiger Airlines investment decision will be: Price of the capital goods Real interest rate

Other things equal (ceteris paribus) a rise in the real interest rate will make investment less attractive.

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Other things equal (ceteris paribus) a rise in the price of capital goods will make investment less attractive. Cost vs. Benefits The benefit of a new plane is value of the additional output it provides to Tiger Airlines. The change in output for an increase in capital is called the marginal product of capital (MPK). Tiger Airlines will invest provided: Value of marginal product of capital Cost of capital
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Saving, Investment and Financial Markets In an economy with no access to international capital markets: National Saving = Investment. The supply of saving by HH, businesses, and government and the demand for saving (for investment) by business are equated by the financial markets.

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

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I(r) S, I Initial Equilibrium r r S

I
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Saving and Investment New Technology r r` r I` I

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Saving and Investment Initial Equilibrium r r S

I
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Saving and Investment Increase in Budget Deficit S` r r` r S

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

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