Savings & Investment
How investment raises full potential
Real
Interest
Rate
Id
$ Investment
The investment demand curve is the same as the Demand Curve in Loanable Funds
Investment
Real
Interest
Rate
Id
$ Investment
•
Investment (I) is a volatile & very important component of AD (AD = C + I + G + NX)
• Changes with level of interest rates, investment outlook, etc…
Investment
• Investment has 3 subcomponents:
Real
Interest
Rate
– New capital expenditure by firms
– New housing expenditure by households
– Net inventories (unsold)
Id
$ Investment
GDP counts goods when built----not when sold!
Capital Goods:
Most important component of I
Firm builds new plants or ↑ # of machines etc…
Step #1 (short run)=> AD ↑
Step #2 (long run) => LRAS ↑ & PPF ↑ (full potential ↑)
Should a firm Invest?
• The real return on investment = ror
– Ror = Return adjusted for inflation
• The price of the loan in real terms = r
Real
Interest
Rate
Id
– Real interest rate = r
• If ror
> r => then make investment
$ Investment
Example:
•
•
•
Borrow $10,000 at 10% interest per year for capital investment
Investment will raise profits by $1,800 per year
Interest costs per year = $1,000
MAKE THAT INVESTMENT!
ROR > R
$1,800 > $1,000
GDP Leakage
• GDP = C + I + G + (X – M)
• Leakage to GDP:
S+T+M
(S = Savings T= taxes M = Imports)
• Injections to GDP:
I+G+X
(Investment, Gov’t, Exports)
• Only in equilibrium do: Leakage = Injections
S+T+M=I+G+X
Deriving Savings
• GDP is both total income and total expenditure:
Y = C + I + G + NX
• Assume a closed economy – (one that does not engage in trade)
Y=C+I+G
• Subtract C & G from both sides:
Y–C–G=I
Derived Savings continued..
• New Equation:
Y–C–G=I
{------------------------}
• This equals total income after paying for C & G
• Y – C – G is known as Savings (S)
(what you don’t spend, you save)
• For the economy as a whole, savings must equal investment:
Savings = Investment
S=I
National, Private & Public
• National Saving
– Income that remains after paying for C + G
– Sum of public & private savings
– Equals Y – C – G
Y=C+I+G
• Private Saving
– Income that households have left after taxes & consumption
– Equals Y – T – C (T=Taxes)
• Public Saving
– Amount of tax revenue government has left after spending
– Equals T – G (T=Taxes)
Worksheet
Example:
Investing Incentives
• A tax credit on capital investment
Capital Goods
------------------------------
Real
Interest
Rate r ------------------2
E2
a) Demand Increases
Due to Gov’t incentive
S1
b) AD ↑ because I ↑
r1 -------------- E1
Q1 Q2
D1
D2
c) More Investment today
leads to ↑PPF & LRAS
in long run
Qty
Loanable Funds
Government Policies
• Gov’t Policies greatly affect Saving & Investment
• Gov’t Incentives:
– Lower Taxes on Savings
• Interest on bonds, dividends on stocks
• ↑ supply of loanable funds which lowers the real interest rate
– Tax credits on Investment
• Tax credits on purchase of capital goods
Changing Saving Incentives
Real
Interest
Rate
Supply, S1
S2
Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
4%
2. . . . which
reduces the
equilibrium
interest rate . . .
Demand
0
$1,200
$1,600
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)