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Lecture 7:

Savings, Investment and Government Debt

September 18, 2014

Prof. Wyatt Brooks

Announcements
Problem Set 1 returned
Groups for in-class presentations will be
announced today

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Financial Markets and Growth


Financial Markets matter for growth
China: Big movement of money in and out of
the country
Korea: Huge money flowing into the country
during the height of its growth
Also, they can be at the heart of crises
Mexico: 1994
Russia: 1998
Asian Financial Crisis: 1997
Argentina over and over
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Investment and Savings


Two sides of financial markets
Savers: checking accounts, holding stock,
buying bonds, pension funds, etc.
Investors: borrow money to expand business
or meet their cash flow needs
Have to understand both sides of the market,
and how they interact

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Different Kinds of Saving


Private saving
= The portion of households income that is
not used for consumption or paying taxes
=YTC
Public saving

= Tax revenue less government spending


=TG

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

National Saving
National saving

= private saving + public saving


=
=

(Y T C) +

(T G)

Y C G

= the portion of national income that is not used


for consumption or government purchases

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Saving and Investment


Recall the national income accounting identity:
Y = C + I + G + NX
For now, focus on the closed economy case:
Y=C+I+G

Solve for I:
I = YCG

national saving

= (Y T C) + (T G)

Saving = investment in a closed economy


SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Budget Deficits and Surpluses


Budget surplus
= an excess of tax revenue over govt spending

= TG
= public saving

Budget deficit
= a shortfall of tax revenue from govt spending
= GT
= (public saving)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

U.S. Budget Deficits and Surpluses,


Fraction of GDP (1929 2012)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

The Meaning of Saving and Investment


Private saving is the income remaining after
households pay their taxes and pay for
consumption.

Examples of what households do with saving:


Buy corporate bonds or equities
Purchase a certificate of deposit at the bank
Buy shares of a mutual fund
Let accumulate in saving or checking account
Reduce credit card balances
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

The Meaning of Saving and Investment


Investment is the purchase of new capital.
Examples of investment:
General Motors spends $250 million to build
a new factory in Flint, Michigan.

You buy $5000 worth of computer equipment


for your business.

Your parents spend $300,000 to have a new


house built.

Remember: In economics, investment is NOT


the purchase of stocks and bonds!
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

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The Market for Loanable Funds


A supply-demand model of the financial system

Helps us understand
how the financial system coordinates
saving & investment
how government policies and other factors
affect saving, investment, the interest rate

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

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The Market for Loanable Funds


Assume: only one financial market

All savers deposit their saving in this market.


All borrowers take out loans from this market.
There is one interest rate, which is both the
return to saving and the cost of borrowing.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

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The Market for Loanable Funds


The supply of loanable funds comes from saving:
Households with extra income can loan it out
and earn interest.
Public saving, if positive, adds to national saving
and the supply of loanable funds.
If negative, it reduces national saving and the
supply of loanable funds.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

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The Slope of the Supply Curve


Interest
Rate

Supply

6%

3%

60

80

An increase in
the interest rate
makes saving
more attractive,
which increases
the quantity of
loanable funds
supplied.

Loanable Funds
($billions)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

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The Market for Loanable Funds


The demand for loanable funds comes from
investment:
Firms borrow the funds they need to pay for
new equipment, factories, etc.
Households borrow the funds they need to
purchase new houses.

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

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The Slope of the Demand Curve


A fall in the interest
rate reduces the cost
of borrowing, which
increases the quantity
of loanable funds
demanded.

Interest
Rate

7%

4%
Demand

50

80 Loanable Funds
($billions)

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

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Equilibrium
Interest
Rate

Supply

The interest rate


adjusts to equate
supply and demand.
The equilibrium
quantity of loanable
funds equalizes
investment and saving.

5%

Demand

60

Loanable Funds
($billions)

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Policy 1: Saving Incentives


Interest
Rate

S1

S2

5%
4%
D1

60 70

Tax incentives for


saving increase
the supply of L.F.
which reduces the
eqm interest rate
and increases the
eqm quantity of L.F.

Loanable Funds
($billions)

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Policy 2: Investment Incentives


Interest
Rate

An investment tax
credit increases the
demand for L.F.

S1

6%

5%
D2

which raises the


eqm interest rate
and increases the
eqm quantity of L.F.

D1

60 70

Loanable Funds
($billions)

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ACTIVE LEARNING

Exercise
Use the loanable funds model to analyze
the effects of a government budget deficit:

Draw the diagram showing the initial


equilibrium.

Determine which curve shifts when the


government increases its budget deficit.

Draw the new curve on your diagram.


What happens to the equilibrium values of the
interest rate and investment?
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ACTIVE LEARNING

Answers
Interest
Rate

S2

S1

2
A budget deficit reduces
national saving and the
supply of L.F.
which increases
the eqm interest rate
and decreases the
eqm quantity of L.F.
and investment.

6%
5%

D1

50 60

Loanable Funds
($billions)
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Budget Deficits, Crowding Out,


and Long-Run Growth
Our analysis: Increase in budget deficit causes
fall in investment.
The government borrows to finance its deficit,
leaving less funds available for investment.

This is called crowding out.


Investment determines the size of the physical
capital stock and is one of the factors affecting
national income.

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Example:
Why is the saving rate in China so high?
China has a very high rate of savings
It is the second largest economy, so this implies
an extremely high quantity of savings

Huge implications for international asset markets


Very low interest rates
A lot of money available for borrowing
but why does China save so much?

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Savings Around the World


http://www.google.com/publicdata/explore?ds=d
5bncppjof8f9_&ctype=l&met_y=ny_gdp_pcap_p
p_cd#!ctype=m&strail=false&bcs=d&nselm=s&m
et_s=ny_gds_totl_cd&scale_s=lin&ind_s=false&i
fdim=country&pit=1284609600000&hl=en_US&d
l=en_US&ind=false

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The International Allocation Puzzle


One puzzling feature of international capital flows:
Typically, capital flows from poor, fast growing
countries to rich, slow growing countries

This is a puzzle for macroeconomic models


Meaning it does not happen in our usual
models, but it does in the data

The reason we have trouble rationalizing this:


If you are going to be much richer in the future,
you should prefer to borrow today to consume
and pay it off in the future when youre rich
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Example: China
China has an extremely high savings rate and very
fast growth

They use their savings to buy low return US


assets and send a lot of Chinese goods to the US

Normally we think of people wanting to smooth


their consumption over time
Would prefer constant consumption today and
tomorrow to very low consumption today and
very high consumption tomorrow

Yet this would predict that the US should be


lending to China now
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Possible Explanations
Many possible explanations have been proposed:

Unusual age structure in China from the one child


policy (Modigliani and Gao, 2004)
In the near future, Chinese population will be
very old so they are saving now to support
consumption then

Bad financial markets in China require


entrepreneurs to save (Buera and Shin, 2011)

Better insurance markets in the US make


foreigners want to save here (Mendoza, Quadrini,
Rios-Rul, 2009)
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Possible Explanations
Many possible explanations have been proposed:

Currency manipulation strategy:


Normally if trade deficits are large, currency
prices adjust to balance trade
With high taxes and capital controls, the
Chinese government uses dollars that enter the
economy to purchase US government assets
Keeps the RMB from adjusting in value
Great example of a policy that maximizes
Chinese GDP but is bad for Chinese welfare

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Next Class
Next class: read chapter 14

Dont forget to start working on Problem Set #2

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