Savings & InvestmentHow investment raises full potential

Id

RealInterestRate

$ Investment

Investment• Investment (I) is a volatile & important component

of GDP (GDP = C + I + G + NX)– Changes with level of interest rates, investment outlook, etc…

• Investment has 3 subcomponents:– New capital expenditure by firms– New housing expenditure by households – Net inventories (unsold)

Capital Goods:

Most important component of I

Firm builds new plants or ordermore machines etc…

Raises long run full potential

Id

RealInterestRate

$ Investment

GDP counts goods when built----- not when sold!

Should a firm Invest?• The real return on investment = ror

– Return adjusted for inflation

• The price of the loan in real terms = r– Real interest rate = r

• If ror > r => then make investment

MAKE THAT INVESTMENT!ROR > R

$1,800 > $1,000

Id

RealInterestRate

$ 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

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 = InjectionsS + 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

• 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)

Y = C + I + G

Worksheet

Example: Investing Incentives• A tax credit on capital investment

RealInterestRate

Qty Loanable Funds

D1

S1

---------------------------

r1

Q1

E1

a) Demand Increases Due to Gov’t incentive

b) AD ↑ because I ↑

c) More Investment todayleads to ↑PPF & LRAS

in long run

Capital Goods

D2

-------------------------------------

r2

Q2

E2

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

Loanable Funds(in billions of dollars)

0

RealInterestRate

Supply, S1 S2

2. . . . whichreduces theequilibriuminterest rate . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Demand

Tax incentives forsaving increase thesupply of loanablefunds . . .

5%

$1,200

4%

$1,600