Week 18 - Saving, Capital Formation

Question 1

Savings

Answer 1

Current income minus spending on current needs

Question 2

Savings rate

Answer 2

Savings divided by income

Question 3

Wealth

Answer 3

The value of assets minus liabilities

Question 4

Assets

Answer 4

Anything of value that a person owns

Question 5

Liabilities

Answer 5

The debt a person owes

Question 6

Balance sheet

Answer 6

A list of an economic unit’s assets and liabilities

Question 7

Real interest rate (r0)

Answer 7

The rate at which the real purchasing power of a financial asset increases over time.
Real interest rate (r) = nominal interest rate (i) - rate of inflation (π)
r = i - π

Question 8

Stock value

Answer 8

The value of an asset at a given time.

Question 9

Flow value

Answer 9

The percentage change of a stock value across a period of time.

Question 10

Uses of flow vs stock values

Answer 10

Stock values provide a snapshot of the current state of the economy whereas flow values show how the economy changes over time.

Question 11

Capital gains

Answer 11

Selling an asset for profit - selling price > purchase price.
Capital gains are taxed at a lower rate than ordinary income to promote investment and economic growth.

Question 12

Capital losses

Answer 12

Selling an asset at a lower price than it was worth at purchase - selling price < purchase price.

Question 13

Change in wealth equation

Answer 13

Change in wealth = Savings + capital gains - capital losses.

Question 14

Reasons for household savings: Life-cycle savings

Answer 14

Saving now to meet long term objectives. E.g., retirement, buying a house, paying for children’s university costs.

Question 15

Reasons for household savings: Precautionary savings

Answer 15

Saving as a protection against setbacks and income fluctuations. E.g., loosing your job, car crash, home repairs.

Question 16

Reasons for household savings: Bequest savings

Answer 16

Saving to be able to pass wealth to children or future generations. Mainly for higher income groups.

Question 17

Reasons for household savings: Wealth accumulation

Answer 17

Saving to be able to purchase an asset that generates income or appreciation in value over time. E.g., property investment, buying a business.

Question 18

Reasons for household savings: Consumption smoothing

Answer 18

Saving during periods of high income and spending during periods of low income. Consumption smoothing aims to maintain a relatively stable standard of living throughout their lifetime.

Question 19

Life-cycle saving theory

Answer 19

Early years is the borrowing phase - consumption > income. Substituting current for future consumption.
Middle years is the saving phase - consumption < income. Substituting future for current consumption.
Retirement is the dis-saving phase - consumption > income. Consuming saved wealth.
Life-cycle saving theory suggest people save when they are younger and have relatively low incomes and spend when they are older and have higher incomes.

Question 20

Production and income for the economy

Answer 20

Y = C + I + G + NX
Y – aggregate income or expenditures (total income)
C – consumption expenditure
G – government purchases of goods and services
I – investment spending
NX – net exports (exports - imports)

Question 21

National savings (S national)

Answer 21

Assuming NX = 0 for simplicity, current income (GDP or Y) minus spending on current needs (consumption (C) + government spending (G)).
S national = Y - C - G
National savings can then be split up into private and public savings.

Question 22

Net taxes (T)

Answer 22

T = total taxes - transfer payments - interest payments
Total taxes: taxes paid by the private sector to the government.
Transfer payments: payments the government makes to the public for which it receives no current goods or services in return e.g., social security, welfare payments.
Interest payments: payments made by the government to the private sector, often government bonds.

Question 23

Private savings (S private)

Answer 23

The amount of the private savings income (GDP or Y) minus taxes and consumption expenditure (current needs)
Private sector is made up of households and businesses.
S private = Y - T - C
Y - aggregate income or expenditures (total income)
T - net taxes
C - consumption expenditure

Question 24

Public savings (S public)

Answer 24

The amount of the public sector’s income (taxes) minus government spending (current needs)
Public sector is the government.
S public = T - G
T - net taxes
G - government spending

Question 25

National savings in the form of public and private savings

Answer 25

S national = S private + S public S private + S public = (Y – T – C) + (T – G) (Y – T – C) + (T – G) = Y – C – G Y – C – G = S national

Question 26

Importance of national savings

Answer 26

National savings determines a countries ability to invest in new capital goods.

Question 27

Government budget

Answer 27

The plan for intended spending and raising revenue (taxes) by the government, often over a financial year.

Question 28

States of the government budget

Answer 28

Balanced budget: Happens when government spending equals net tax receipts. Government budget surplus: net tax collections are greater than spending (T-G). Budget surplus causes public saving. Government budget deficit: net tax collections are less than spending (T-G). Budget deficit causes public dissaving.

Question 29

Investment

Answer 29

The creation of new capital goods and housing. From the economy point of view, the reason for national savings is to fund investment. Investment spending is only undertaken if it is expected to be profitable (cost-benefit principle).

Question 30

Investment decision

Answer 30

Rate of return: the value of marginal product expressed as a percentage of the purchase price for an investment. Rate of return = VMP/PK VMP - value of marginal product (the benefit of the investment) PK - price of investment. An investment will be profitable if rate of return (VMP/PK) > real interest rate (r)