Question

In a speech at the CFA Society of Nebraska in February \(2007,\) William Poole (former Chairman of the St. Louis Federal Reserve Bank) said: Over most of the post-World War II period, the personal saving rate averaged about 6 percent, with some higher rates from the mid- 1970 s to mid-1980s. The negative trend in the saving rate started in the mid- 1990 s, about the same time the stock market boom started. Thus it is hard to dismiss the hypothesis that the decline in the measured saving rate in the late 1990 s reflected the response of consumption to large capital gains from corporate equity [stock]. Evidence from panel data of houscholds also supports the conclusion that the decline in the personal saving rate since 1984 is largely a consequence of capital gains on corporate equities. a. Is the purchase of corporate equities part of household consumption or saving? Explain your answer. b. Equities reap a capital gain in the same way that houses reap a capital gain. Does this mean that the purchase of equities is investment? If not, explain why it is not.

Short answer

a. The purchase of corporate equities is part of household saving. b. Purchasing equities is not considered investment but a form of saving.

Step-by-step solution

Understanding Household Purchases

Identify whether the purchase of corporate equities is counted under household consumption or saving. Households purchase equities typically not for consumption but as a way to save money and invest, aiming for potential future profits or capital gains.

Defining Household Savings

Household saving refers to the portion of disposable income not used for current consumption. When households purchase corporate equities, they are essentially saving money and transferring it into investment vehicles.

Conclusion for Part (a)

The purchase of corporate equities is considered a part of household saving, not consumption. This is because the purchase is an investment with the expectation of future returns rather than immediate consumption.

Capital Gains on Equities

Understand if capital gains from equities classify the purchase as an investment. Capital gains refer to the increase in the value of an asset over time.

Distinguishing Investment from Savings

Investment usually refers to the purchase of capital goods that contribute to production or economic growth, such as machinery or infrastructure. While purchasing equities is a form of investment for households, in macroeconomic terms, it is a transfer of ownership rather than a new investment in production.

Conclusion for Part (b)

The purchase of equities by households does not count as investment in the macroeconomic sense. It represents savings being allocated into financial assets rather than direct investment in productive assets.

Key concepts

Personal Saving Rate

The personal saving rate is a key economic measure that indicates the percentage of disposable income that households save rather than spend. For example, if households save 6% of their disposable income, this means they are setting aside \(6 for every \)100 they earn. Understanding this rate helps to gauge the financial health and future consumption potential of households.

Historically, the personal saving rate averaged around 6% post-World War II. However, this rate has fluctuated over time due to various economic conditions and consumer behaviors. One significant factor affecting the saving rate is capital gains from investments. For instance, during the stock market boom of the 1990s, many households experienced substantial capital gains, which led to increased spending and a decline in the saving rate.

Capital Gains

Capital gains refer to the profit earned from the sale of an asset. This could be stocks, real estate, or other investments. When the value of an asset increases from its purchase price, the difference is the capital gain.

For example, if a household buys corporate equities for \(1,000 and later sells them for \)1,500, the capital gain is $500. This gain often encourages households to spend more, because they feel wealthier due to their increased asset values. This phenomenon was noted in the 1990s when the rising stock market led many households to spend more and save less, thereby reducing the personal saving rate.

Household Consumption

Household consumption refers to the total value of goods and services consumed by households. This includes everything from groceries and rent to entertainment and travel. It is a major component of GDP and reflects the living standards and economic health of a population.

Unlike saving or investing, which are aimed at future financial security, consumption deals with immediate needs and wants. In the context of purchasing corporate equities, this activity is not classified under household consumption, as equities are not immediately consumed but are rather saved and potentially earn returns in the future.

Corporate Equities

Corporate equities, commonly known as stocks, represent ownership shares in a corporation. When households purchase these equities, they become partial owners of the company and are entitled to a share of the profits, typically in the form of dividends and capital gains.

Purchasing corporate equities is a common form of saving and investment for households. These investments are intended to grow over time, providing financial returns. However, in macroeconomic terms, the purchase of corporate equities is classified as a transfer of ownership rather than a direct investment in productive assets like machinery or infrastructure.

Macroeconomic Investment

Macroeconomic investment involves the creation of new assets that contribute to economic growth. This includes spending on infrastructure, machinery, technology, and other productive assets.

Unlike purchasing corporate equities, which is a financial investment, macroeconomic investment directly impacts the production capacity of an economy. When individuals or businesses invest in building factories or upgrading technology, they are making macroeconomic investments that lead to increased productivity and economic growth.

For households, purchasing equities represents a shift from one form of savings to another, but it does not create new productive assets. Thus, while it is a method of saving and investing at an individual level, it does not qualify as macroeconomic investment.