Chapter 2(A)

1. Chapter 2(A) SAVING AND WEALTH

2. 3. SAVING AND WEALTH • Wealth • Household wealth = a household’s assets minus its liabilities • National wealth = sum of all households’, firms’, and governments’ wealth within the nation • Saving by individuals, businesses, and government determine wealth

3. SAVING AND WEALTH AGG. SAVING (+) PRIVATE SAVING GOVT. SAVING (Spvt) (Sgvt ) NATIONAL SAVING (S)

4. 3.1 Measures of Aggregate Saving • Saving = current income – current spending • Saving rate = saving/current income • Private saving = private disposable income – consumption Spvt = (Y+NFP – T+TR+INT) – C …(2.6)

5. 3.1 Measures of Aggregate Saving • Measures of aggregate saving • Government saving = net government income – government purchases of goods and services Sgovt= (T – TR – INT) – G………………….(2.7) • Government saving = government budget surplus = government receipts – government outlays • Government receipts = tax revenue (T) • Government outlays = government purchases of goods and services (G) + transfers (TR) + interest payments on government debt (INT)

6. 3.1 Measures of Aggregate Saving GOVT. SAVING (BUDGET SURPLUS) GOVT. RECEIPTS (T) GOVT. OUTLAYS minus = TAX REVENUE = Govt. purchases of goods & services (G) + Transfers (TR) + Int. payments on govt. debts (INT)

7. 3.1 Measures of Aggregate Saving • Government budget deficit = – Sgovt • Simplification: count government investment as government purchases, not investment

8. 3.1 Measures of Aggregate Saving • Measures of aggregate saving • National saving • National saving = private saving + government saving • S = Spvt + Sgovt …………………………… (2.8) = [Y + NFP – T + TR + INT – C] + [T – TR – INT – G] =Y+NFP – C – G= GNP – C – G

9. 3.1 Measures of Aggregate Saving • Uses of Private Saving • S = I + (NX + NFP) = I + CA • Derived from: • S = Y + NFP – C – G and • Y= C + I + G + NX • CA = NX + NFP = Current account balance

10. 3.1 Measures of Aggregate Saving • Uses of Private Saving • Spvt= I + (–Sgovt) + CA (2.11) • (using S = Spvt + Sgovt) • Saving is used in 3 ways • Investment (I) • Government Budget Deficit (-Sgovt) • Current Account Balance

11. 3.2 WEALTH • Household Wealth = Assets – Liabilities • National Wealth = Sum of households’ wealth + firms’ + government wealth • Savings by individuals, businesses and government determine wealth.

12. 3.3 Relating Saving and Wealth • Stocks and flows • Flow variables: measured per unit of time (GDP, income, saving, investment) • Stock variables: measured at a point in time (quantity of money, value of houses, capital stock) • Flow variables often equal rates of change of stock variables • Wealth and saving as stock and flow (wealth is a stock, saving is a flow)

13. 3.3 Relating Saving and Wealth • National wealth: domestic physical assets + net foreign assets • Country’s domestic physical assets (capital goods and land) • Country’s net foreign assets = foreign assets (foreign stocks, bonds, and capital goods owned by domestic residents) minus foreign liabilities (domestic stocks, bonds, and capital goods owned by foreigners)

14. 3.3 Relating Saving and Wealth • Changes in national wealth are a change in the value of existing assets and liabilities. • National Saving raises wealth. • Wealth matters because the economic well-being of a country depends on it

15. 3.3 Relating Saving and Wealth

16. 3.3 Relating Saving and Wealth • Application: Wealth Versus Saving • We might not need to worry about the decline in the personal saving rate because: • private saving is the relevant measure of saving • the personal saving rate may be revised upward in the future • the personal saving rate ignores capital gains; as people’s wealth rises, their saving rate declines

17. 4. REAL GDP, PRICE INDEXES AND INFLATION • Real GDP • Nominal variables are those in dollar terms • Problem: Do changes in nominal values reflect changes in prices or quantities? • Real variables: adjust for price changes; reflect only quantity changes

18. 4.1 Real versus nominal GDP • The output of a company or the entire economy can be expressed in real or nominal terms. • Nominal GDP • Also called current-dollar GDP. It is the dollar value of an economy’s final output measured at current market prices.

19. 4.1 Real versus nominal GDP • Real GDP • Example : of computers and bicycles • Nominal GDP is the dollar value of an economy’s final output measured at current market prices • Real GDP is an estimate of the value of an economy’s final output, adjusting for changes in the overall price level

20. 4.1 Real versus nominal GDP • Real GDP • Also known as constant-dollar GDP. It is the measure of the physical volume of an economy’s final production. • Real GDP = Nominal GDP • GDP deflator

21. 4.1 Real versus nominal GDP Methods for breaking changes in nominal variables into part owing to physical quantities and part owing to changes in prices.

22. 4.2 Calculation of Real Output with Alternative Base Years • How much increase in nominal output is attributable to an increase in physical output? • Simple way to remove the effect of the price changes, we focus on the quantity changes of the output . • This can be done by measuring the value of production in each year by using prices from some base year.

23. 4.2 Calculation of Real Output with Alternative Base Years

24. 4.3 Price Indexes • Price index measures the average level of prices for some specific set of goods and services, relative to the prices in a specified base year. • GDP deflator – is a price index that measures the average level prices of good and services included in GDP. •  GDP deflator = 100 x nominal GDP/real GDP • Note: For base year, Price (P) = 100

25. 4.3 Price Indexes • Price Indexes • Consumer Price Index (CPI) • Monthly index of consumer prices; • index averages 100 in reference base period (1982 to 1984) • Based on basket of goods in expenditure base period (2003 to 2004) • Need for base year to revised frequently.

26. 4.3 Price Indexes • Price Indexes • Box 2.2 on the computer revolution and chain-weighted GDP • Choice of expenditure base period matters for GDP when prices and quantities of a good, such as computers, are changing rapidly • BEA compromised by developing chain-weighted GDP • Now, however, components of real GDP don’t add up to real GDP, but discrepancy is usually small

27. 4.4 Inflation • An important variable that is measured with price index is the rate of inflation. • In general terms, to calculate inflation rate: t+1= (Pt+1 – Pt)/Pt = Pt+1/Pt • t + 1 = rate of inflation • Pt = price level period t • Pt +1 = price level period t +1

28. 4.4 Inflation • Box 2.3: Does CPI inflation overstate increases in the cost of living? • The Boskin Commission reported that the CPI was biased upwards by as much as one to two percentage points per year • One problem is that adjusting the price measures for changes in the quality of goods is very difficult

29. 4.4 Inflation • Price Indexes • Box 2.3: Does CPI inflation overstate increases in the cost of living? • Price indexes with fixed sets of goods don’t reflect substitution by consumers when one good becomes relatively cheaper than another • This problem is known as substitution bias

30. 4.4 Inflation • Price Indexes • Box 2.3: Does CPI inflation overstate increases in the cost of living? • If inflation is overstated, then real incomes are higher than we thought and we’ve overindexed payments like Social Security • Latest research (July 2006) suggests bias is still 1% per

31. 4.5 Interest rate • Real vs. nominal interest rates • A rate of return promised by a borrower to a lender. • An interest rate indicates how quickly a nominal, or dollar, value of an interest bearing assets increases over time but it does not reveal how quickly the value of the asset changes in real or purchasing-power terms.

32. 4.5 Interest rate • Real vs. nominal interest rates • Real interest rate (r): the real rate of return or purchasing power of the assets increases over time. • Nominal interest rate (): rate at which the nominal value of an asset increase over time

33. 4.5 Interest rate • Real vs. nominal interest rates • Real interest rate • =Nominal interest rate – Inflation rate • r = i - 

34. 4.5 Interest rate • Real vs. nominal interest rates • Expected real interest rate • =Nominal interest rate – expected rate of inflation • r = i - e • The expected interest real interest rate is the correct interest rate to use for studying most types of economic decision. • If  = e, real interest rate = expected real interest rate

35. 4.5 Interest rate • Real vs. nominal interest rates • Interest rate: a rate of return promised by a borrower to a lender • Real interest rate: rate at which the real value of an asset increases over time • Nominal interest rate: rate at which the nominal value of an asset increases over time