Lecture 5: Saving and Investment

We showed previously how Crusoe could divide his GDP between consumption and investment by dividing his time between the production of goods he would consume immediately and goods that would yield future benefits. In a modern society, the division is more complicated. We now turn to the subject of what determines the division of GDP between consumption and investment. We will also go beyond Crusoe and include government borrowing and international trade in our discussion.

One thing that makes our task simple is that the resources for investment come from saving. Therefore, rather than talk about how people decide how much to consume, we will talk about how people determine how much to save. Since income after taxes goes for either consumption or saving, it is a matter of twiddle dee or twiddle dum.

Saving and Investment as Different Concepts

Many people confuse the concepts of saving and investment. The differences are important, so we will spend some time on the issue.

Saving takes place when people abstain from consumption, that is, when they consume less than their income. Investment takes place when we purchase new capital equipment or other assets that make for future productivity. Investment does not mean buying stocks or bonds. Here are some important facts:

· For Robinson Cruse, the difference between saving and investment is a distinction without a difference. Since he does all saving and all investment, they are automatically equal. However, for the larger economy, this is not true. Investment funds come either from our own saving or from someone else's saving.

· The motive for saving is one of deferring your consumption to a later day. We save when we consume only part of our income now and save for retirement, a rainy day, putting children through college, the summer home, etc.

· The motive for investment is to make money. Investment takes place when we purchase plants or equipment, which make workers and businesses more productive in the future.

· Ultimately saving and investment must be equal, (subject to a couple of complications that make for nice exam questions). As you will see in a moment, you can think of saving as a supply of funds for investment and investment as a demand for funds. We will later draw supply and demand curves and show how saving and investment are equated.

Table 5-1 Some Examples of Saving and Investment
The Facts	Saving or Investment?
The owner of Miller's Pizzeria has after tax income of $50,000 this year. He spends $40,000 on consumption, and decides to save the rest by investing in a $10,000 certificate of deposit at the 87^th National Bank. This brings his accumulated deposits to $50,000.	$ 10,000 in saving. The word “invest” is misused. The rest of the deposits constitute savings, or cumulative saving.
The owner decides to purchase a new $10,000 pizza oven, paying for it by taking $10,000 out of the savings account at the 87^th National Bank.	Investment.
In the next year, the owner decides to purchase a new, high tech oven for $25,000, paying for it by leaving $5,000 in earnings in the business and taking an additional $20,000 loan from the Bank.	Both. The new oven is an investment of $25,000, and he saved $5,000 this year by not taking part of the money out of the business for spending.

Warning required by the Economist-General:

· Points are deducted on all exams for confusing saving and investment.

Investment

Some Preliminaries on Interest Rates

An understanding of interest rates is important for understanding saving and investment. Put simply, an interest rate is the price of a loan, expressed as a percentage of the amount loaned each year. Thus, if the interest rate is 6%, and you borrow $100, you must pay back $106 at the end of the year. Moreover, when you deposit $10,000 in a certificate of deposit you are effectively making a loan to the bank or other financial institution. The interest rate is the price the bank pays you. In short, interest is either the reward you get for saving or the premium you pay for having funds now rather than later. As we shall see, the concept of interest is a crucial economics concept.

Why do People Invest?

People invest to make money. They figure that they can earn a higher return on their investment than it costs them to borrow the funds. If they are investing their own funds, then they invest because they figure they can earn more than on any alternative means of holding their savings, such as CD’s or in the stock market.

Some simple examples will make the point. Suppose you have five different one period investment opportunities. Each project requires $30,000. You can invest in any or all of the projects. However, if you borrow, you must repay $30,000, plus the interest rate, (1+r) for each project. Each project has a different projected value next period, as listed in Table 5-2.

Table 5-2 Some Different Investment Projects
Project	Project Cost	Value Next Period	Percent Return
1	$30,000	$30,600	2%
2	$30,000	$31,500	5%
3	$30,000	$32,400	8%
4	$30,000	$33,000	10%
5	$30,000	$33,600	12%

Your demand for investment will now look like the following

Table 5-3 The Demand for Loans
Interest Rate	Total Demand for Loans
13%	0
11%	$30,000
9%	$60,000
7%	$90,000
4%	$120,000
1%	$150,000

In sum, investment demand is a downward sloping function of the interest rate. The less it costs to borrow, the more attractive an investment opportunity becomes. Graphically, the demand for investment funds is, as shown in Figure 5-1, a downward sloping function of the interest rate.

Figure 5-1
Demand for loans

The demand for loans has an inverse relationship with the interest rate. As the real interest rate falls more projects are profitable to undertake

Saving

We now want to discuss the consumer’s saving and consumption decision. Saving is, after all income minus taxes minus consumption. Thus

S = Y – T – C.

That is,

Saving = Income less Taxes less Consumption

Motives for Saving

People save so that they can consume more in the future. A decision to spend now or save is really a choice of when to spend – now or in the future. The decision depends on wealth, disposable income, real interest rates and tastes or preferences for spending now versus waiting. While we will not engage in a complete discussion of the determinants of saving, the following examples will make some of the points.

· Fred and Barney have the same income this year. They are alike in all respect except that Fred gets a big inheritance from his beloved Aunt Matilida this year. Who is likely to save more from this year's income, Fred or Barney? Answer: Fred has more assets that Barney, and can live better. He is likely to spread his largess over several years, meaning that Fred will spend more this year than Barney. In turn, this means less saving this year.

· Fred and Barney have the same income this year. They are alike in all respect except that Barney has a generous pension plan. Fred has none. Who is likely to save more from this year's income, Fred or Barney? Answer: a true measure of assets includes funds in things like pension plans, not just in stocks, bonds and bank accounts. The logic given above applies here, so that Barney is likely to spend more this year than Fred. In turn, this means that Barney will save less this year.

· Fred and Barney have the same income this year. They are alike in all respect except that Barney has just made a killing in the stock market. Fred kept his money in Certificates of Deposit. Who is likely to save more from this year's income, Fred or Barney? Answer: look at the two questions above. Barney will save less this year.

· Fred and Barney have the same income this year. They are alike in all respect except that Fred expects a big pay raise next year. Who is likely to save more from this year's income, Fred or Barney? Answer: just as people base their consumption on assets and income, so too do people base their consumption on current and future income. This means Fred will spend more and save less this year.

· Fred has twice Barney's income this year. Who is likely to save more from this year's income, Fred or Barney? Answer: we just don't have enough information to tell.

Warning required by the Economist-General:

· In an introductory course, our discussion of the determinants of consumption and saving is quite simple. However, all of the examples given above have answers consistent with the more general theory of consumption. We return to examples like these to discuss how taxes and deficits affect saving and consumption.

The Role of Interest Rates

Without getting into a detailed discussion of the determinants of saving, common sense tells us that, the higher the interest rate, the more people will save. This guarantees us that the supply curve will be upward sloping, as shown in Figure 5-2. Of course, the examples we have given above indicate that this supply curve, like most supply curve has supply shifters.

Figure 5-2
Supply of loans

There is a direct relationship between the interest rate and the supply of loans

Equilibrium

We now come to the question of how saving and investment come into balance. The answer, of course, is the interest rate. As Figure 5-3 shows, the intersection of the supply and demand for loans determines the interest rate.

Figure 5-3
Equilibrium interest rate

S, I

r_o

Supply of Loans (Saving)

Demand for Loans (Investment)

The equilibrium interest rate is where the total demand for loans equals the total supply of loans.

Two Important Modifications

While the simple argument

Saving = Investment

captures the important point we want to make, there are two important modifications we must incorporate:

· The government almost never spends exactly what it takes in. In some years, it runs a deficit and borrows additional funds to cover its deficit; in yet other years, it runs a surplus and uses the funds to pay off its debts. In either case, government transactions affect the supply and demand for loans.

· In recent years, Americans have done substantial international borrowing and lending. International lending is around $300 billion per year, while international borrowing runs about $500 billion per year. We cannot neglect the international sector.

We take up each of these issues in turn.

Government Demand for Loans

To get the total demand for loans, we must add another component: the government’s demand for loans to cover its deficit. Note that this is the net demand of all governments, state, federal and local. In some years, this "demand" can be negative, as for example, when the government is paying down its debt. Some people argue that we should then treat the government surplus as a supply of loans. Nevertheless, there is a convention: we always treat the government's deficit as an addition, positive or negative, to the demand for loans.

Figure 5-5 illustrates the possibilities. Suppose the government is running a deficit. Then, as the upper left panel of Figure 5-5 shows, the total demand for loans shifts to the right. If the government is running a surplus, then there is a "negative demand for loans", also known as a surplus. The government's situation looks like the lower left panel of Figure 5-5 and the net effect, as the lower right panel shows, is to shift the demand for loans to the left.

Warning required by the Economist-General:

· Some people would like to argue that, when the government switches from a deficit to a surplus, it is now a supplier of loans instead of a demander. Instead, we should add the surplus to the supply of loans. Do not do that. This is just a convention. We always shift the demand for loans to adjust for the government's surplus or deficit. In any case, it makes no difference in our analysis.

· Why this convention? It is probably because, for most of the time since World War II, the Federal Government has run a deficit. Perhaps economists are creatures of habit.

	Figure 5-5 Total demand for loans
Deficit		Total Demand Investment Demand
Surplus		Investment Demand Total Demand
	A government deficit will cause a shift in the demand for total loans. If the government runs a deficit, total demand shifts to the right. If the government runs a surplus, total demand shifts to the left.

Let us illustrate the two cases. Figure 5-6 shows what will happen if the there is a government surplus. As you can see, the total demand curve lies to the left of the investment demand function. Thus the interest rate is lower than it would be without the deficit.

Figure 5-6
Equilibrium interest rate with Surplus

Funds from govt. Surplus

Funds from private saving

r_o

Total Demand