Session 2. Saving and Investment. The Real Interest Rate. National Accounting

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1 Session 2. Saving and. The Real Interest Rate. v National Accounting Identity v Consumption and Saving v v Equilibrium and the real interest rate v Applications: Farewell to cheap capital? National Accounting The expenditure approach to measuring GDP: GDP = C + I + G + NX C = Private Consumption (Households expenditures excluding housing) I = Private (Infrastructure, Structures, Equipment, Housing) G = Government Spending (Purchases of Goods and Services by Government, excludes Transfers) NX = Net Exports (Exports Imports) 1

2 The income approach: National Income (GNI) = GDP + NFP [NFP = Net Factor Payments] Private Sector (Households and Companies) receive GNI and they use it to: 1. Pay Taxes (T) 2. Buy Consumption Goods (C) National Accounting The difference is what we refer to as Private Saving S private = GNI - T - C = (GDP+ NFP) - T - C Government Saving is the difference between revenues (T) and expenditures (G) S government = T - G National Accounting: Saving and National Saving (S) is the sum of private and public saving: S = S private + S government = [(GDP+NFP) C T] + [ T G ]= S = (GDP+NFP) C G (National Saving is the amount of National Income that is not consumed by the Private Sector or the Government) Using definition of GDP (C + I + G + NX): S = (C + I + G + NX+NFP) - C G = I + (NX + NFP) We defined the sum of NX + NFP as the current account (CA): S = I + CA For a closed economy (CA = 0): S = I 2

3 Theory: Consumption and Saving v Consumption depends on the overall level of resources (income + wealth) Higher income, lower taxes, higher wealth all increase consumption. Expectations about the future matter. v Consumers tend to smooth transitory fluctuations in income. This leads to an intertemporal allocation of resources over time: e.g. winning a lottery or planning for retirement leads to a reallocation of income over time to maintain consumption stable. v The interest rate is the relative price of the future vs. the present. Higher interest rates make consumption in the present less attractive and it tends to lead to a reduction in consumption (although there are income effects that might go in the opposite direction). Consumption and Income Across emerging markets we see a wide range of values for the ratio of (private) consumption to income. Asian countries display low rates of consumption. Country Consumption as % of GDP (2010) Bolivia 62% Chile 59% Bulgaria 61% France 58% Malaysia 48% China 35% 3

4 Assignment 2010 South Africa Singapore New Zealand Mexico Lebanon Japan India Greece France Egypt China Canada Bulgaria Brazil Australia Consumption (C) as % of GDP Assignment 2010 South Africa Singapore New Zealand Mexico Lebanon Japan India Greece France Egypt China Canada Bulgaria Brazil Australia Government Consumption (G) as % of GDP

5 In the US, prior to the 2007 crisis private consumption as a % of income grew by almost 5 percentage points. As a comparison, none of the other advanced economies displayed a similar increase in consumption prior to the crisis. How can this be justified? 75 Household Consumption as % of GDP 70 Consumption and Income France Germany United States United Kingdom Consumption and Wealth During those years, US wealth was increasing at a much faster rate than income (GDP). As a ratio to wealth, consumption decreased from 17% to 15% during But the collapse of housing prices and stock prices in 2008 revealed a very different scenario Wealth (% of GDP) US 5

6 Real Interest Rate r Back to the Theory: Saving and the Interest Rate Saving is an increasing function of r Saving Total (National) Saving = Private saving + Government saving Disposable income - consumption Revenues (taxes)- Expenditures v What is investment? Structures Equipment and software Residential housing Inventories v Facts about investment Fact 1: The most volatile component of output Fact 2: There is a wide variation in investment rates across countries Country rate (2010) Bolivia 17% France 19% China 45% 6

7 in the US (as % of GDP) Inventories Residential Equipment and software 3 Structures Assignment 2010 South Africa Singapore New Zealand Mexico Lebanon Japan India Greece France Egypt China Canada Bulgaria Brazil Australia (I) as % of GDP

8 Assignment 2010 South Africa Singapore New Zealand Mexico Lebanon Japan India Greece France Egypt China Canada Bulgaria Brazil Australia C+I+G as % of GDP Theory: and the interest rate v depends negatively on real interest rate, the nominal interest rate corrected for inflation. v The real interest rate reflects: the cost of borrowing the opportunity cost of using one s own funds to finance investment spending. So, r I v In addition: is affected by expected future profitability of capital (productivity, taxes) 8

9 function Real Interest Rate r is a decreasing function of r Saving and : The Equilibrium The real interest rate is the price that equilibrates saving and investment. Decreases in Saving or increases in drive up the interest rate. r Saving Equilibrium Real interest rate Saving, 9

10 Saving and over the Business Cycle During the business cycle we see fluctuations in investment that drive the real interest rate. New equilibrium Real interest rate Equilibrium Real interest rate r Saving during a boom during a recession Saving, The real interest rate and the business cycle - US During the business cycle we see fluctuations in investment that drive the real interest rate Real Interest Rate GDP Growth 10

11 Saving Glut To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain the relatively low level of long-term real interest rates in the world today Ben Bernanke, March 10, r Saving (1990s) Saving (2000s) Equilibrium Real interest rate Saving, Application: Farewell to Cheap Capital? Going forward we might see increases in investment in emerging countries, possibly combined with increases in consumption in China (lower saving). Among advanced economies we see a trend towards deleveraging (higher saving), but looking beyond the next 5 years we will see an increasing number of workers reaching retirement and using their savings to fund their consumption. What will world (real) interest rates do? r Saving Equilibrium Real interest rate Saving, 11

12 Application: Farewell to Cheap Capital? Application: Farewell to Cheap Capital? 12

13 Session 2. Summary v v Saving depends positively on interest rates: If interest rates increase people save more. depends negatively on interest rates: If interest rates increase, companies invest less. v The Real Interest Rate is the price that ensures that Saving = Saving curve is shifted to the right if: 1. Current output increases 2. Expected future output decreases 3. Wealth decreases 4. Taxes increase 5. Government spending decreases curve is shifted to the right if: 1. (Expected) productivity increases. 2. Taxes on capital decrease. Appendix: Consumption and the interest rate v Income effect If consumer is a saver, a higher interest rate makes him/her better off, which tends to increase consumption today and in the future. v Substitution effect An increase in the interest rate increases the opportunity cost of current consumption, which tends to reduce today s consumption and increase future consumption. v Both effects lead to increase in future consumption Whether today s consumption increases or falls depends on the relative size of the income & substitution effects. 13

14 Appendix: The effect of government deficits during wars r War Saving New equilibrium real rate Equilibrium real rate Saving, Appendix: The effect of government deficits during wars. Military spending and the interest rate in the UK Source: Mankiw 14

15 Exercise: Making sure that investment = saving (in a closed economy) A builds a house that he sells to B. The value of the house is $1,000. B sells food to A for a total of $500. To be able to pay for the house, B borrows $500 from his bank. A s income for the year is $1000 out of which she spends $500on food. She keeps the rest ($500) on her bank account. Calculate: GDP, Consumption, and Saving for each individual and for the economy. Is saving equal to investment? 15

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