Basic Macroeconomics

ECO2021
Martin Shu
Feb 27
Spring 2024
Financial Markets
• Investment, saving, and financial markets

• Interest rates and the demand and supply of funds

• Financial market and goods market

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Financial Institutions
• Financial system: The group of institutions that funnel saving of
one person to fund the investment of another
• Financial markets: Institutions where savers can directly provide
funds to borrowers
• Bond Market: Companies borrow from investors
• Stock Market: Company sells partial ownership
• Financial intermediaries: Institutions through which savers
indirectly provide funds to borrowers
• Banks
• Mutual funds, insurance companies
Investment
• Investment is the purchase of new capital
• The financial system funds new investment
• Examples of investment:
• BYD spends ￥ 15 billion to build an auto parts factory in Xi’an, China
• CUHK Shenzhen purchases lecture theater equipment for ￥ 200,000
• A family purchases a new apartment at ￥ 10 million

In
In macroeconomics,
macroeconomics, the
the purchase
purchase of
of
stocks
stocks or
or bonds
bonds is
is NOT
NOT investment!
investment!
Saving
• Saving is current income minus spending on current needs
• Household 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 stocks
• Purchase a certificate of deposit at the bank
• Deposit into an insurance policy
• Buy shares in a mutual fund
• Keep in saving or checking accounts
Saving vs Wealth: Flow vs. Stock
Flow Stock
• A flow variable is defined per unit of time
■ Income ■ Spending

■ Saving ■ Wage

• E.g. “U.S. consumption was $1.6 trillion in 2001.”

• A stock variable is defined at a point in time
■ Wealth ■ Debt ■ Capital Stock
• The flow of saving causes the stock of wealth to change
• Every dollar a person saves adds to his wealth
• High saving rate today leads to improved standard of living in the future
Thrifts and Spends
• Two families with two saving rates
• Higher saving reduces current
consumption
• But saving allow wealth to grow faster
• Assuming starting income of $40,000
and 8% real interest rate
• From 15 years on, Thrifts consume
more than Spends
Saving and Self-Control
• Psychology suggests that some individuals’ self-control too
weak to produce rational outcomes
• Smoking, obesity, gambling, and spending
• Easy borrowing supports unsustainably high levels of spending
• Credit cards
• Personal loans (e.g., campus loans)
• Devices to support saving
• Make saving automatic and withdrawals costly
• Penalties for early withdrawal of retirement investment funds
• Employee pension/resident pension in China, MPF in Hong Kong, 401(k) in the US
National Saving
• Macroeconomics studies total saving in the economy

• National saving consists of two parts

• Private saving by households and firms
• Public saving by the government

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Private Saving
• Household's total income is GDP or
• Households pay taxes from this income
• Government transfer payments (social welfare, unemployment payments)
increase incomes
• Interest is paid to government bond holders
• Both reduce total taxes paid to the government by households

= Taxes – Transfers – Government interest payments

• Household saving is the portion of household income not used for

consumption or paying taxes
Private Saving
• Private saving is after-tax income less consumption

• Total income includes retained earnings

• Profits not paid as dividends to shareholders
• Private saving is household saving plus business saving
(retained earnings)
• In the US, business saving makes up the majority of private saving
• Business savings can fund purchase of new capital equipment
Public Saving
Budget surplus: Excess tax revenue over government spending
T>G
Budget deficit: Shortfall of tax revenue from government spending
G>T
Balanced Budget: Government spending equals net tax receipts
G=T
Public saving:
National Saving
• National saving is the sum of private saving and public saving

National Saving = Private Saving + Public Saving

• National saving is therefore

• When ,
In
In aa closed
closed economy,
economy,
Saving
Saving == Investment
Investment
US National Saving, 1960 - 2006
National Saving Rates, 1992 - 2012
Trends in World Saving

• US saving rates low compared to other countries

• Household saving has declined since early 1980s
• 0.4% of household income in 2006
• China’s saving rates are high compared to other countries
• Japan’s saving rates are high, but have been falling since 1990
• Europe’s saving rates have been stable
Reasons for Household Saving
1. Life-cycle saving is to meet long-term objectives
■ Retirement
■ Purchase a home

■ Children's college attendance

2. Precautionary saving is for protection against setbacks

■ Loss of job
■ Medical emergency

3. Bequest saving is to leave an inheritance

■ Mainly higher income groups
Household Saving in China
• Household saving have increased since mid-1980s
• Fast economic and income growth
• Habit formation: saving became social norm and virtue
• Life-cycle motives are important
• Demographic structure favors saving
• Mainly working age population
• Fewer children and retired
• Longer life expectancy
• Precautionary saving
• Relatively weak public heath and retirement scheme
China’s Saving and Investment: 1985-2018

60

50

40

30

20

10
World Gross savings (% of GDP) China Gross savings (% of GDP) China Total investment (% of GDP)

0
Household Saving in Japan
• After World War II, household saving were 15-25%
• Declined after 1990
• Life-cycle motives are important
• Long life expectancy
• Retire relatively early; long retirement period
• Before 1990s, age structure of the population favored saving
• Increasing number of retired since 1990s
• Housing prices and down payment requirements were very high
• Increasing saving for real estate investment
• Property values decreased after 1990, saving falls
Explaining US Household Saving
US saving rate may be depressed by
• Social security, Medicare, and other government programs
• Can’t explain why US saving is less than Europe
• Mortgages with small or no down payment
• Encourages borrowing
• Increasing value of stocks and growing home values
• Confidence in a prosperous future
• Increasing income inequality
• Demonstration effects and status goods
• ‘Keeping up with the Joneses’
US Saving Rates, 1960 - 2016
The Bull Market of the 1990s and
Real Estate Bubble of the 2000s
• Stock prices rose rapidly in 1990s
• Capital gains on stocks increased household wealth
• Likely decreased household saving
• Internet bubble burst and stock market crashed, 2000-2001
• Household saving remained low
• Value of privately-owned homes increased rapidly in 2000s
• Household wealth increased
• Home equity loans allowed borrowing against home value
US Stock Prices, 1960-2004
Exercise 1
• Suppose GDP equals $10 trillion, consumption equals $6.5
trillion, the government spends $2 trillion, and has a budget
deficit of $300 billion
• Find public saving, taxes, private saving, national saving, and
investment
Exercise 2
• Now suppose the government cuts taxes by $200 billion
• In each of the following two scenarios, determine what happens
to public saving, private saving, national saving, and
investment.
1. Consumers save the full proceeds of the tax cut.
2. Consumers save half of the tax cut and spend the other half
Exercise 2
GDP is $10 trillion, consumption is $6.5 trillion, the government
spends $2 trillion, and has a budget deficit of $300 billion
Government cuts taxes by $200 billion
• Scenario 1 – Consumers save the full proceeds of the tax cut
Exercise 2
GDP is $10 trillion, consumption is $6.5 trillion, the government
spends $2 trillion, and has a budget deficit of $300 billion
Government cuts taxes by $200 billion
• Scenario 2 – Consumers save half of the tax cut and spend the
other half
Discussion
• In both scenarios, public saving falls by $200 billion, and the
budget deficit rises from $300 billion to $500 billion
1. If consumers save the full $200 billion, private saving rises by
$200 billion. National saving is unchanged, and investment is
unchanged
• If households save 100% of a tax cut, tax changes will not affect the
national saving rate
2. If consumers save $100 billion and spend $100 billion, then
national saving and investment each fall by $100 billion
• If households do not save 100% of a tax cut, tax changes will affect the
national saving rate
Discussion
Recall the two scenarios:
1. Consumers save the full proceeds of the tax cut.
2. Consumers save half of the tax cut and spend the other
half

• Which of these two scenarios do you think is more realistic?

• Why is this question important?
Saving and Supply of Funds
Funds in the financial markets come from saving
• Households with extra income can loan it out and earn interest
• Profits retained by firms to fund investments
• Public saving adds to national saving and supply of loanable funds
• If negative, it reduces national saving and the supply of loanable funds
Saving and the Real Interest Rate
• Saving often take the form of financial assets that pay a return
• Interest-bearing checking ■ Bonds
• Savings ■Certificates of Deposit
• Mutual funds ■ Stocks
• The real interest rate () is the nominal interest rate () minus the
rate of inflation ()
• The increase in purchasing power from a financial asset
• Marginal benefit of the extra saving
The Slope of the Supply Curve
Interest
Rate Supply of funds

Increase in the interest

6% rate makes saving
more attractive and
raises the quantity of
3% loanable funds supplied

60 80 Loanable Funds
($billions)
Investment and Capital Formation
• Investment is the creation of new capital goods and housing
• Demand for 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 or apartments
• Firms buy new capital to increase profits
• Cost-Benefit Principle
• Pursue investment if cost is less than benefit
Investment Decisions
• Cost of using machinery or other capital:
• Price of the capital good
• Real interest rates
• Annual cost = real interest rate  price of equipment
• Benefit is the value of the marginal product of the capital
• New revenues generated
• Technical innovation increases benefits
• Lower taxes increase benefits
• Higher price of the output increases benefits
The Investment Demand Curve
Interest
Rate Some investment project
are profitable even at a
high interest rate.

High Others are profitable only

Profit at lower interest rates.
Project Less Investment
Profits Projects

Investment
Demand
Demand for Loanable Funds
Interest
Rate
A fall in the interest
rate reduces the cost
7% of borrowing, which
increases the quantity
of loanable funds
4% demanded.

Demand

50 80 Loanable Funds
($billions)
Saving, Investment, and Financial Markets

• A supply-demand model of the financial system

• What affects saving, investment, the interest rate
• How the financial system coordinates saving & investment
• Assumption: 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
Financial Market
Saving S
• Equilibrium interest rate equates

Real interest rate (%)

the amount of saving with the
investment funds demanded
• If r is above equilibrium, there is a surplus
of saving
• If r is below equilibrium, there is a shortage r
of saving
• Interest rates adjust to equalize Investment I
saving and investment
S, I
Saving and Investment
Financial Market and Goods Market
Interest rates adjust to equilibrate the loanable funds market,
making invest equal to saving
If the loanable funds market is in equilibrium
S=Y–C–G=I
This implies
Y=C+I+G
Thus,
Equilibrium in
Financial Market  Equilibrium in
Goods Market
Increase in Investment Demand
• E.g., new technology raises S
marginal productivity of capital

Real interest rate (%)

• Increases the demand for investment funds
• Movement up the saving supply curve F
• Higher interest rate r'
E
• Higher level of saving and investment r
I'
I

A A'
Saving and Investment
Investment in Computers, 1960-2007

• Digitization may have driven increases in productivity

• Computer investment faster than other capital goods
From Deficit to Surplus to Deficit
• The US government budget moved from deficit to surplus, then to
deficit again from 1980 to 2007
• Tax changes
• Reagan tax cuts in early 1980s
• Tax increases in early 1990s (under Clinton)
• Bush tax cuts in early 2000s
• Spending
• Government military spending increased in 1980s and again in 2000s (wars
in Iraq and Afghanistan)
• Tax receipts decreased during the 2008 financial crisis further
deteriorating the budget deficit
US Public Debt
Budget Deficit and Investment
S'
S
• Government budget deficit increases
• Reduces national saving
Real interest rate (%)

• Movement up the investment curve

F • Higher interest rate
r' E • Lower level of saving and investment
r
I

A' A
Saving and investment
Crowding Out Effect
• When government spending increases beyond tax revenue
• Government has to borrow to finance its deficit
• Less funds available for private investment
• This is called crowding out.
• Recall that investment is important for long-run growth
• Hence, budget deficits reduce growth rates and future standard
of living, unless the deficit is for public investment
Low National Saving in the US
• National saving determines a country's ability to invest in new
capital goods
• National saving rate has been declining since 1970s
• Business saving is the only segment that has remained stable
• Household saving have been falling
• US federal government’s large budget deficits have contributed
to a decline in the US national saving rate
Increasing National Saving
• How to increase national saving rates
• Reduce government budget deficit or increase government budget
surplus
• Increase household saving
• 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 in the long run
Exercise
Use the loanable funds model to analyze the effects of a
government budget surplus:
• Draw a diagram showing an initial equilibrium with a balanced
budget
• Determine which curve shifts when the government runs a
budget surplus
• Draw the new curve on your diagram
• What happens to the equilibrium values of the interest rate and
investment?
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