CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Define and explain the relationships among capital,
investment, wealth, and saving.
2
Explain how investment and saving decisions are
made and how these decisions interact in financial
markets to determine the real interest rate.
3
Explain how government influences the real interest
rate, investment, and saving.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Physical capital
The tools, instruments, machines, buildings, and other
constructions that have been produced in the past and
that are used to produce goods and services.
Financial capital
The funds that firms use to buy and operate physical
capital.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Capital and Investment
Gross investment
The total amount spent on new capital goods.
Net investment
The change in the quantity of capital—equals gross
investment minus depreciation.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Figure 24.1
illustrates the
relationship
between capital
and investment.
On January 1,
2003,Tom’s DVD
Burning, Inc. had
DVD recording
machines valued
at $3,000.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
During 2003, the
value of Tom
machines falls by
$2,000,
depreciation.
He spent $3,000
on new
machines—gross
investment.
Tom’s net investment was $1,000, so at the end of
2003,Tom had capital valued at $4,000.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Wealth and Saving
Wealth
The value of all the things that a person owns.
Saving
The amount of income that is not paid in taxes or spent
on consumption goods and services—adds to wealth.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Financial Markets
Financial markets
The collections of households, firms, governments,
banks, and other financial institutions that lend and
borrow.
 Global Financial Markets
Lenders seek the highest possible real interest rate, and
borrowers seek the lowest possible real interest rate in
a single global financial market.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Financial markets are organized in four groups:
•
•
•
•
Stock markets
Bond markets
Short-term securities markets
Loans markets
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Stock Markets
Stock
A certificate of ownership and claim to the profits that a
firm makes.
Stock market
A financial market in which shares of companies’ stocks
are traded.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Bond Markets
Bond
A promise to pay specified sums of money on specified
dates; it is a debt for the issuer.
Bond market
A financial market in which bonds issued by firms and
governments are traded.
24.1 CAPITAL, INVESTMENT, WEALTH, SAVING
Short-Term Securities Markets
Short-term securities are commercial bills and Treasury
bills—promises by large firms and government to pay
an agreed sum 90 days in the future.
Loans Markets
Banks and other financial institutions lower the cost of
financing firms’ capital expenditures by accepting shortterm deposits and making longer-term loans.
24.2 INVESTMENT, SAVING, AND INTEREST
Investment Demand
Other things remaining the same, the higher the real
interest rate, the smaller is the quantity of investment
demanded; and lower the real interest rate, the greater
is the quantity investment demanded.
24.2 INVESTMENT, SAVING, AND INTEREST
The real interest rate is the opportunity cost of the funds
used to finance the purchase of capital, and firms
compare the real rate of interest with the rate of profit
they expect to earn on their new capital.
Firms invest only when they expect to earn a rate of
profit that exceeds the real interest rate.
The higher the real interest rate, the fewer projects that
are profitable, so the smaller is the amount of
investment demanded.
24.2 INVESTMENT, SAVING, AND INTEREST
Investment Demand Curve
Investment demand
The relationship between the quantity of investment
demanded and the real interest rate, other things
remaining the same.
Investment demand is shown by an investment demand
schedule or and investment demand curve.
24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.2 shows
investment demand.
The table and figure
show the quantity of
investment
demanded at five
real interest rates.
Points A through E
on the investment
demand curve
correspond to the
rows in the table.
24.2 INVESTMENT, SAVING, AND INTEREST
Changes in Investment Demand
When the expected rate of profit changes, investment
demand changes.
Other things remaining the same, the greater the
expected profit from new capital, the greater is the
amount of investment.
24.2 INVESTMENT, SAVING, AND INTEREST
The many influences on expected profit can be
placed in three groups:
• Objective influences such as the phase of the
business cycle, technological change, and
population growth
• Subjective influences summarized in the phrase
“animal spirits”
• Contagion effects summarized in the phrase
“irrational exuberance”
24.2 INVESTMENT, SAVING, AND INTEREST
Shifts of the Investment Demand Curve
When investment demand changes, the investment
demand curve shifts.
24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.3 shows changes in
investment demand.
An increase in the expected
profit increases investment
demand and shifts the
investment demand curve
rightward to ID1.
A decrease in the expected
profit decreases investment
demand and shifts the
investment demand curve
leftward to ID2.
24.2 INVESTMENT, SAVING, AND INTEREST
Saving Supply
The higher the real interest rate, the greater is the
quantity of saving supplied, other things remaining the
same.
The lower the real interest rate, the smaller is the
quantity of saving supplied, other things remaining the
same.
24.2 INVESTMENT, SAVING, AND INTEREST
The real interest rate is the opportunity cost of
consumption expenditure.
A dollar spent is a dollar not saved, so the interest that
could have been earned on that saving is forgone.
24.2 INVESTMENT, SAVING, AND INTEREST
Saving Supply Curve
Saving supply
The relationship between the quantity of saving
supplied and the real interest rate, other things
remaining the same.
Saving supply is illustrated by a saving supply schedule
or a saving supply curve.
24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.4 shows
saving supply.
The table and figure
show the quantity of
saving supplied at
five real interest
rates.
Points A through
E on the saving
supply curve
correspond to the
rows in the table.
24.2 INVESTMENT, SAVING, AND INTEREST
Changes in Saving Supply
The three main factors that influence saving supply are:
• Disposable income
• Buying power of net assets
• Expected future disposable income
24.2 INVESTMENT, SAVING, AND INTEREST
Disposable income
Income earned minus net taxes.
The greater a household’s disposable income, other
things remaining the same, the greater is its saving.
The greater the buying power of the net assets a
household has accumulated, other things remaining the
same, the less it will save.
The higher a household’s expected future disposable
income, other things remaining the same, the smaller is
its saving.
24.2 INVESTMENT, SAVING, AND INTEREST
Shifts of the Saving Supply Curve
• Along the saving supply curve, all the influences
on saving other than the real interest rate remain
the same.
• A change in any of these influences on saving
changes saving supply and shifts the saving
supply curve.
24.2 INVESTMENT, SAVING, AND INTEREST
Figure 24.5 shows a change in
saving supply.
The saving supply curve shifts
rightward from SS0 to SS1 if:
• Disposable income increases
• The buying power of net
assets decreases
• Expected future disposable
income decreases
24.2 INVESTMENT, SAVING, AND INTEREST
The saving supply curve shifts
leftward from SS0 to SS2 if:
• Disposable income
decreases
• The buying power of net
assets increases
• Expected future disposable
income increases
24.2 INVESTMENT, SAVING, AND INTEREST
Financial Market
Equilibrium
Figure 24.6 shows how the
real interest rate is
determined.
• ID is the investment
demand curve
• SS is the saving supply
curve
24.2 INVESTMENT, SAVING, AND INTEREST
1. If the real interest rate is 8
percent a year, the quantity
of investment demanded is
less than the quantity of
saving supplied.
2. If the real interest rate is 4
percent a year, the quantity
of investment demanded
exceeds the quantity of
saving supplied.
24.2 INVESTMENT, SAVING, AND INTEREST
3. When the real interest rate
is 6 percent a year, the
quantity of investment
demanded equals the
quantity of saving supplied.
There is neither a shortage
nor a surplus of saving, and
the real interest rate is at its
equilibrium level.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Government Budget and Government Saving
GDP is the sum of consumption
expenditure, C; investment, I;
government purchases, G; and
net exports, NX.
In the global economy, net
exports are zero, so for the
world as a whole:
Y=C+I+G
24.3 GOVERNMENT IN THE FINANCIAL MARKET
GDP equals total income, which is the sum of
consumption expenditure, saving, S, and net taxes,
NT. So:
Y = C + S + NT
By combining these two ways of looking at GDP, you
can see that:
C + I + G = C + S + NT
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Because consumption is on both sides of this equation,
we can subtract C and simplify the equation to:
I + G = S + NT
Now subtract government purchases from both sides of
this equation to obtain:
I = S + (NT – G)
This equation tells us that investment is financed by
private saving and government saving, NT – G.
Government saving, NT – G, is also the government
budget surplus.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Total saving equals private
saving plus government saving.
So when the government has a
budget surplus, it contributes
toward financing investment.
But when the government has
a budget deficit, it competes
with businesses for private
saving and decreases the
amount available for
investment.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Effect of Government Saving
A government budget surplus increases total saving
supply.
To find total saving supply, we must add the
government budget surplus to private saving supply.
An increase in saving supply brings a lower interest
rate, which decreases the quantity of private saving
supplied and increases the quantity of investment.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Figure 24.7 shows the effects
of government saving.
With balanced government
budgets, the real interest rate
is 6 percent a year and
investment equals saving at
$10 trillion a year.
1. A government budget
surplus of $2 trillion is added
to private saving to determine
the saving supply curve SS.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
2. The real interest rate falls to
4 percent a year.
3. Private saving decreases to
$9 trillion.
4. Total saving and investment
increase to $11 trillion.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Government Deficit and Crowding Out
A government budget deficit works in the opposite way
to the surplus. It decreases total saving.
To find total saving, subtract the government budget
deficit from private saving.
A decrease in total saving brings a higher interest rate,
which increases the quantity of private saving supplied
but decreases investment in a crowding-out effect.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Crowding-out effect
The tendency for a government budget deficit to
decrease investment.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
Figure 24.8 shows a crowding-out
effect.
With balanced government
budgets, the real interest rate is 6
percent a year and investment
equals saving at $10 trillion a year.
1. A government budget deficit is
negative government saving
(dissaving). Subtract the
government deficit from private
saving to determine the saving
supply curve SS.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
2. The real interest rate rises to 8
percent a year,
3. Private saving increases to $11
trillion, and
4. Total saving and investment
decrease to $9 trillion.
Investment is crowded out.
24.3 GOVERNMENT IN THE FINANCIAL MARKET
The Ricardo-Barro Effect
The proposition that a government budget deficit has no
effect on the real interest rate or investment.
The Ricardo-Barro effect operates if private saving
supply changes and the private saving supply curve
shifts to offset any change in government saving, so
that the total saving supply is unchanged when the
government budget changes.
Most economists regard this outcome unlikely.