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
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
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
Assignment 2010 South Africa Singapore New Zealand Mexico Lebanon Japan India Greece France Egypt China Canada Bulgaria Brazil Australia Consumption (C) as % of GDP 35 37 59 57 58 58 61 61 54 0 10 20 30 40 50 60 70 80 90 59 58 65 75 75 78 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 11 12 12 12 11 13 0 5 10 15 20 25 30 16 18 18 20 21 21 21 22 25 4
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 65 60 55 50 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 2002-2006. But the collapse of housing prices and stock prices in 2008 revealed a very different scenario. 480 460 440 420 400 380 360 340 320 Wealth (% of GDP) US 5
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
in the US (as % of GDP) 24 21 18 15 12 9 6 Inventories Residential Equipment and software 3 Structures 0 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 Assignment 2010 South Africa Singapore New Zealand Mexico Lebanon Japan India Greece France Egypt China Canada Bulgaria Brazil Australia (I) as % of GDP 18 20 19 20 21 17 19 19 22 23 0 10 20 30 40 50 25 28 29 32 45 7
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 73 101 98 97 99 98 109 102 104 94 102 100 100 100 122 0.0 20.0 40.0 60.0 80.0 100.0 120.0 140.0 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
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
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. 10 8 6 4 2 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010-2 -4 Real Interest Rate GDP Growth 10
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, 2005. 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
Application: Farewell to Cheap Capital? Application: Farewell to Cheap Capital? 12
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
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
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