Chapter Ten • Capital, Investment, and Saving
OUTLINE • Growth and fluctuations of investment and the capital stock • Fluctuations in the real interest rate • How business investment decisions are made • How household saving decisions are made
OUTLINE [cont.] • How investment and saving interact to determine the real interest rate • How government fiscal policy may influence the real interest rate, saving, and investment • How international borrowing and lending are determined
Capital and Investment Physical Capital is the total quantity of plant, equipment, infrastructure, buildings, and inventories -- durable goods used to produce goods and services. Gross investment is expenditure on new physical capital. Finance Capital is purchasing power used to finance [i.e. pay for] investment.
Capital and Investment Depreciation is the wearing out and scrapping of existing physical capital. Net investment is gross investment minus depreciation.
Capital and Investment Private investment is business investment plus investment in new housing. It includes additions to inventories. Government investment is the part of government purchases that creates social infrastructure capital -- public capital, like schools, roads, barracks, prisons, drains, storm-water ponds, etc.
Real Interest Rates Interest Rates The real interest rate, or rate of return on capital, is in terms of real goods and services, the nominal interest rate adjusted for inflation. • The nominal or money interest rate is the interest rate expressed in terms of money. • The real interest rate equals approximately the nominal interest rate minus the inflation rate --> money = real + inflation.
Investment Decisions Business investment decisions are decisions to spend on physical capital, which by definition lasts years. These decisions are influenced by: 1) The expected profit rate 2) The real interest rate
Investment Decisions The Expected Profit Rate Ceteris paribus, the more profit you expect, the more you will do something. So, for given real interest rate, the greater the expected profit rate from new capital, the greater will be the amount of investment.
Investment Decisions The Expected Profit Rate • The net revenue stream from an investment in a project is equal to the expected total revenue from sales minus the expected cost of inputs [e.g. labor and materials, intermediates], year by year over the life of the project. • The expected profit rate is the interest rate that makes the Net Present Value of the project zero, i.e. that makes the present value of the net revenue stream equal to the value of the expenditure on the investment.
Investment Decisions The Expected Profit Rate Four Major Factors Affecting the Expected Profit Rate 1) The phase of the business cycle 2) Advances in technology 3) Taxes 4) Expectations of future business conditions
Investment Decisions The Expected profit rate is the real rate (as % per annum) funds used to finance an investment project are expected to earn, comparing net revenue stream to the cost of the project. The Real Interest Rate • Ceteris paribus, the lower the real interest rate, the greater is the amount of investment. • The real interest rate is the opportunity cost of funds to finance investment.
Investment Decisions The Real Interest Rate (cont.) • If the real interest rate is larger than the expected profit rate, a firm will not invest in new capital because it could earn more by lending the funds to other firms. • More investment projects will be expected to be profitable at low interest rates, and fewer at high interest rates.
Investment Decisions Firms will have different views of expected profitability, and the future will not be exactly as ‘expected’ -- so some actual investments ‘fail,’ i.e. turn out not to be profitable. BUT, overall it will still be true that the lower the real interest rate, and the better expectations of the future, the more investment there will be. So, Investment Demand illustrates the relationship between investment expenditure and the real interest rate.
Investment Demand: Stylized Example Investment (trillions of 1992 dollars) Expected profit rate a 4 1.0 1.2 1.4 b 6 0.8 1.0 1.2 c 8 0.6 0.8 1.0 Real interest rate (percent per year) Low Average High
A rise in the real interest rate decreases investment c b a A fall in the real interest rate increases investment ID Investment Demand 12 10 8 Real interest rate (percent per year) 6 4 2 0 0.6 0.8 1.0 1.2 1.4 1.6 Investment (trillions of 1992 dollars)
An increase in the expected profit rate increases investment demand A decrease in the expected profit rate decreases investment demand ID1 ID0 ID2 Investment Demand 12 10 Real interest rate (percent per year) 8 6 4 2 0 0.6 0.8 1.0 1.2 1.4 1.6 Investment (trillions of 1992 dollars)
Saving Decisions National Saving The sum of private saving and government saving. Private Saving is the sum of household saving and business saving. Business saving is net profits retained in the business, i.e. not distributed to owners. Household saving is disposable income minus consumption expenditure. As measured, it ignores ‘capital gains’ of households.
Saving Decisions Some factors affecting household saving are: • The real interest rate • Disposable income • Purchasing power of net assets [i.e. real wealth] • Expected future income
Saving Decisions The Real Interest Rate • Changes in the interest rate have two effects on saving, in opposite directions. • The interest rate is the opportunity cost of not saving, i.e. consuming now; so a higher interest rate makes consuming now more expensive, consumption decreases, you save more. • But higher interest rates mean higher future income from net financial assets, i.e. households expect higher future income, so will consume more now, save less.
Saving Decisions • Real interest rate [continued] • These two effects go in opposite directions; which dominates is an empirical question. Despite your textbook, the answer is not clear -- higher real interest rates may or may not increase saving in the aggregate. • Empirical evidence is very clear on one point -- higher real interest rates on particular financial assets do increase the flow of saving into those assets, as one would expect.
Saving Decisions Disposable Income • The greater a household's disposable income the greater is its saving [and its consumption]. Purchasing Power of Net Assets • Net assets are assets minus debts, i.e. real wealth. • The greater the purchasing power of a household’s net assets the less is its saving, ceteris paribus; the increase in wealth from stock market and house-value gains probably largely explains current low HH savings rates in the US.
Saving Decisions Expected Future Income Ceteris paribus, the lower a household’s expected future income, the greater its saving now. *************************************** Saving Supply Illustrates the relationship between saving and the real interest rate
Saving Supply [stylized] Real interest rate Saving (percent per year) (trillions of 1992 dollars a 4 0.9 b 6 1.0 c 8 1.1 Note this is inelastic -- doubling the interest rate increases saving by only 22%. Empirically, this is plausible for financial saving in the US.
SS A rise in the real interest rate increases saving c b A fall in the real interest rate decreases saving a Saving Supply [stylized] 12 10 8 Real interest rate (percent per year) 6 4 2 0 0.8 0.9 1.0 1.1 1.2 1.3 Saving (trillions of 1992 dollars)
SS2 A decrease in saving supply SS1 An increase in saving supply Saving Supply [stylized] 12 SS0 10 8 Real interest rate (percent per year) 6 4 2 0 0.8 0.9 1.0 1.1 1.2 1.3 Saving (trillions of 1992 dollars)
Equilibrium in the World Economy Real interest rates are not the same in every country for many reasons. For example: -- owners of assets perceive investments in some countries as riskier than in others. -- the expected profit rate in some countries is much larger than in others, often compensating for the risk differences. -- perceptions of likely future inflation in each country vary.
Equilibrium in theWorld Economy If two countries with equal perceived risk had different interest rates, people would borrow in the country with a low interest rate and lend in the country with a high interest rate. This arbitrage [jargon word] would quickly equalize interest rates in the two countries.
Equilibrium in theWorld Capital Market a 4 8 5 b 6 6 6 c 8 4 7 [Stylized: “risk-adjusted” interest rates.] Investment Saving Real interest rate (percent per year) (trillions of 1992 dollars)
Surplus of saving-- real interest rate falls SS Equilibrium ID Shortage of saving-- real interest rate rises Equilibrium in theWorld Capital Market 12 10 8 Real interest rate (percent per year) 6 4 2 0 4 6 8 10 World saving and world investment (trillions of 1992 dollars)
The Role of Government • Part of the capital stock arises from government investment. • Investment is financed by total saving, which is made up of private saving plus government saving [plus foreign saving]. • Therefore, government actions influence investment, saving, and the real interest rate.
The Role of Government • Most governments are small, but governments in aggregate add up to a lot -- 20 to 40 % of GDP moves through governments at all level in most countries. • For all governments in the world, in aggregate, net saving fluctuates, but recently has been close to 10 percent of total saving. • Sometimes, net government saving is negative.
The Role of Government Expenditure:GDP = C + I + G + (X -M) Use of Income: GDP = C + S + T Therefore, C + I + G + (X-M) = C + S + T So, I = S + (T – G) + (M - X) S is private saving; [T-G] is government saving; and [M-X] is foreign saving [or the trade deficit]
The Role of Government • If net taxes, T, exceed government purchases, G, the government has a budget surplus and government saving is positive. • If government purchases exceed net taxes, the government has a budget deficit and government saving is negative.
The Role of Government Direct Effect of Government Saving • Government Dis-saving occurs if government saving is negative, i.e. G>T, budget deficit. • The crowding-out effect is the tendency for a government budget deficit to decrease private investment. • Raising the real interest rate “crowds out” private investment and slows the rate of economic growth
Government deficit: dissaving SS A Crowding-Out Effect 8 7 PS 6.0 Real interest rate (percent per year) Government deficit raises interest rate, decreases investment, and increases private saving 5.0 3.0 ID 9 10 11 0 World saving and world investment (trillions of 1992 dollars)
The Role of Government Indirect Effect of Government Saving • Government saving has an indirect effect on the world capital market because it may influence private saving. • A change in government saving may change the real interest rate and thereby change the amount of private saving supplied. • There may also be a more indirect effect.
The Role of Government The Barro-Ricardo Effect This suggests that a government deficit has no effect on the real interest rate or investment. • Deficit spending requires a government to sell bonds to pay for those expenditures not paid for by taxes • It must collect more taxes in the future to pay the interest on the larger quantity of bonds that are outstanding • Taxpayers will see that their taxes will be higher in the future
The Role of Government The Barro-Ricardo Effect We are trying to see why deficit spending might not change saving or interest rates. Note this view is extreme, and is perhaps unlikely [especially if we remember people do die, but governments don’t always]: • Households expecting less future disposable income, save more. • In the extreme case, they will increase saving by the same amount that the government is dis-saving through its deficit.
PS1 Government deficit: dissaving A Barro-Ricardo Effect Private saving increases by the amount of the Government deficit PS0=SS 8 7 6 Real interest rate (percent per year) 5 4 ID 3 0 8 10 12 World saving and world investment (trillions of 1992 dollars)
Saving and Investment inthe World Economy • Saving supply and investment demand in the world economy determine the world real interest rate [Remember: money interest rates can vary a lot from country to country because of inflation and risk differences]. • Saving does not necessarily equal investment in a single national economy.
S & I in the World Economy • National investment is financed by national saving plus net borrowing from the rest of the world [M - X] -- ‘foreign saving.’ • For the world as a whole, international borrowing equals international lending [or it should -- actually, the numbers don’t add properly -- we have a reported deficit with the rest of the universe -- because international trade and payments records are often wrong (meaning inaccurate).]