Chapter 9

Saving and Capital Formation

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 Savings and Wealth
• Saving is current income minus
spending on current needs
– The saving rate is saving divided by
income
• Wealth is the value of assets minus
liabilities
– Assets are anything of value that one
owns
– Liabilities are the debts one owes

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 Flow Values and Stock Values
• A flow value is defined per unit of time
– Income ■ Spending
– Saving ■ Wage
• A stock value is defined at a point in time
– Wealth ■ Debt
• The flow of savings causes the stock of
wealth to change
– Every dollar a person saves adds to his wealth

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 The Bathtub Example

• The amount of water in the bathtub is stock, the

rate at which water flows into the bathtub (e.g. 2
liters per minute) is a flow
• Flow is the rate of change in the stock
• A high rate of saving today leads to higher wealth
in the future

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 Saving and the Real Interest
Rate
• Savings often take the form of financial
assets that pay a return
– Interest bearing bank deposits
– Bonds
– Stocks

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 Saving and the Real Interest
Rate
• The real interest rate (r) is the nominal
interest rate (i) minus the rate of
inflation ()
– The increase in purchasing power from a
financial asset
– Marginal benefit of the extra saving

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• The real interest rate is the reward for
saving, which provides extra purchasing
power in the future.
• The higher is the real interest rate, the
higher is the future reward.
• Ceteris paribus, the higher is the real
interest rate, the more you save.

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 Aside

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 Aside
• CBRT increased interest rates on Friday
(implicitly) due to increased risk after
March 19.
• Why?
• Increase demand for TL assets, reduce
demand for FX assets, decrease
inflationary pressures.

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 Low U.S. Household Savings
Rate
• Savings rate may be depressed by
– Social Security, Medicare, and other
government programs for the elderly
– Mortgages with small or no down payment
– Confidence in a prosperous future
– Increasing value of stocks and growing
home values
– Demonstration effects and status goods

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Trump on Social Security

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 High Household Savings in
China
• Chinese households save about 25% of disposable
income, a very high rate
– This is new: was only 10% until late 1980s
• Life-cycle and precautionary motives are important
– Wealth has come recently to China
– Young people richer than older people
– Saving of young outweighs dissaving of old
– Limited social safety net (i.e. assistance for the needy)
• Little opportunity for individuals to borrow, savings
are necessary for large purchases

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 Household Savings in Turkey
• Historically Turkish savings rate has
been lower than its emerging market
counterparts (but still higher than the
US, for example)
• The policies that are adopted since
2021 made this picture worse

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 Total Savings Rates by Country

https://worldpopulationreview.com/country-rankings/savings-rate-by-country

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 National Savings
• Macroeconomics studies total savings in the
economy
– Household savings is one component
– Business and government savings are other parts
• Start with the definition of production and income
for the economy
Y = C + I + G + NX

Y = aggregate income
C = consumption G = government
expenditure purchases of goods
and services
I = investment spending NX = net exports
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 Calculate National Savings
• Assume NX = 0 for simplicity
• National savings (S) is current income less
spending on current needs
– Current income is GDP or Y
• Spending on current needs
– Exclude all investment spending (I)
– Most consumption and government spending
is for current needs
• For simplicity, we assume all of C and all of G are
for current needs
S=Y–C–G

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 National Savings, 1960-2019
• Since 1960, national savings rate has
been 13 – 15% in recent years
– Less volatile than household savings

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 Private Saving
• Private saving is household plus business saving
• Households’ total income is Y
– Households pay taxes from this income (↓ disposable income)
– Government transfer payments increase household income (↑
disposable income)
• Transfer payments are made by the government to
households without receiving any goods in return
– Interest is paid to government bond holders (↑ disposable
income)

T = Taxes – Transfers – Government interest payments

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Examples of transfer payments

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 Notes
• Recall from Chapter 5 (end of chapter question 2d)
that interest paid on government bonds are not
included in GDP.
• That’s why in calculating Private Savings we add
interest on government bonds as part of total
disposable income
• Note: From the perspective of income approach,
any interest payment you receive on your bond
holdings would be included in GDP, regardless of
private or public. But because interest payments
are subtracted from government and firm’s income
(in the income approach), they offset each other
and are excluded from GDP.

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 Private Saving
• Private saving is after-tax income less consumption
SPRIVATE = Y – T – C
• Private saving is done by households and
businesses
– Household saving or personal saving is done by families
and individuals
– Business savings makes up the majority of private
saving
• Business savings can purchase new capital
equipment

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 Public Saving and National
Saving
• Public saving is the amount of the public sector's
income that is not spend on current needs
– Public sector income is net taxes
– Public sector spending on current needs is G
SPUBLIC = T – G
• National saving (S) is private savings plus public
savings
SPRIVATE + SPUBLIC = (Y – T – C) + (T – G)

S=Y–C–G

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 The Government Budget
• Balanced budget occurs when
government spending equals net tax
receipts
– Government budget surplus is the excess of
government net tax collections over spending
(T – G)
• Budget surplus is public savings
– Government budget deficit is the excess of
government spending over net tax collections
(G – T)
• Budget deficit is public dissavings

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Three Components of National
Saving, 1960-2019

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Government Savings in Turkey

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Trump on balanced budget

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 Summary: Determinants of
Savings
• Real interest rate
• Any change in Y, C or G (S=Y-C-G):
– Higher/lower growth
– changes in consumer confidence
– cultural changes
– government policies

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 Investment and Capital
Formation
• Investment is the creation of new capital
goods and housing
• Firms buy new capital to increase
profits
– Cost-Benefit Principle
– Cost is the cost of using the machine or
other capital
– Benefit is the value of the marginal product
of the capital

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 The Investment Decision
• Two important costs
– Price of the capital goods
– Real interest rates
• Opportunity cost of the investment
• Value of the marginal product of the capital
(VMP=P×MPK) is its benefit
– Net of operating and maintenance expenses
and of taxes on revenues generated
– Technical innovation increases benefits
– Lower taxes increase benefits
– Higher price of the output increases benefits

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 Summary: Determinants of
Investment
• On the cost side:
– Real interest rate
– Price of capital good
– Uncertainty
• On the benefit side (VMP=Poutput × MP):
– Price of final good
– Technological innovation
– Business taxes
– Operating expenses
– Uncertainty
– Business confidence
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 Saving, Investment, and
Financial Markets
• Supply of savings (S) is the amount of
savings that would occur at each possible
real interest rate (r)
– The quantity supplied increases as r increases
• Demand for investment (I) is the amount
of savings borrowed at each possible real
interest rate
– The quantity demanded is inversely related
to r

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 Financial Market
• Equilibrium interest
rate equates the Saving S

Real interest rate (%)

amount of saving
with the investment
funds demanded
• If r is above equilibrium, r
there is a surplus of
savings
Investment I
• If r is below equilibrium,
there is a shortage of
savings S, I
Saving and investment
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 Financial Markets Are Markets
• Financial markets adjust to surpluses
and shortages as any other market
does
– Equilibrium Principle holds
• Changes in factors other than real
interest rates will shift the savings or
investment curves
– New equilibrium

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 Technological Improvement
• New technology raises
S
marginal productivity
Real interest rate (%)

of capital
F – Increases the demand
r'
E
for investment funds
r – Movement up the
I' savings supply curve
I
– Higher interest rate
– Higher level of savings
and investment
Saving and Investment

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 Let’s consider alternative
scenarios
C I G Y S
1 100 100 100 300 100
2 50 100 100 250 100
3 50 100 150 300 100
4 100 50 150 300 50

• Consider the first scenario as the baseline

• In the second scenario, consumption (and hence output) declines but national
savings remain the same
• In the third scenario the decline in consumption is offset by the increase in G,
total output and savings remain the same
• In the fourth scenario, the increase in G is offset by a decline in I, reducing total
savings while total output remains the same
• If the increase in C or G takes place at the expense of I, then total
savings decline.
• Let’s now see an example where the increase in G takes place at the
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expense of a decline in I, everything else remaining constant:
 Example
• Suppose government expenditure
increases, leaving taxes the same
• Assume private savings do not change
(i.e. the components of private savings,
Y and C remain the same)
• This implies that I has to decline to keep
Y unchanged.
• The scenario is consistent with the
economy in the long-run.
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 Government Budget Deficit
Increases
S'
• Government budget
S
deficit increases
Real interest rate (%)

• Reduces national saving

F
• Movement up the
r' E
investment curve
r
• Higher interest rate
I
• Lower level of savings and
investment
• Private investment is
Saving and investment
crowded out

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 Crowding Out Effect
• The tendency of government budget
deficits to reduce investment spending
is called crowing out
• ↑G,↓I

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Aside: The effects of tariffs

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 The effects of tariffs
• Increase in taxes
– Private savings decrease, public savings
increase, leaving the net impact unchanged
– Investment in manufacturing increase (?)
• Increase in inflation (decline in real GDP)
– A decline in Y would reduce overall savings
• Increase in uncertainty
– Decline in investment
– Increase in precautionary savings?

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 Increase National Saving
• Policymakers know the benefits of
increased national saving rates
– Reducing government budget deficit would
increase national saving
• Political problems
– Increase incentives for households
• Federal consumption tax
• Reduce taxes on dividends and investment income
• Higher national saving rate leads to
greater investment in new capital goods
and a higher standard of living

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 Announcements
• You can skip the following questions:
• 1, 4, 6, 7

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Question 12

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Question 3

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• 3a)
S(private)=S(Household)+S(Business)
• =200+400=600
• S(Public)=T-G
• =(150-100)-100=-50
• S(National)=S(Private)+S(Public)=550
• Savings rate=S/Y=550/2200=25%

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• 3b)
• S(Private)=(Y-T)-C
• =(6000-1200+400)-4500
• =700
• S(Public)=Budget Surplus=100
• S(National)=S(Private)+S(public)=800

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• 3c)
• Y=C+I+G=4000+1000+1000=6000
• S(Private)=Y-T-C
• =6000-1500+500-4000=1000
• S(Public)=T-G
• =1500-500-1000=0
• S(National)=1000
• Savings rate=1000/6000=16 %

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