A Penny Saved is a Penny at 4.7% Earned
This lesson printed from:
Posted December 19, 1999
Author: Conor Irons
Posted: December 19, 1999
Updated: December 4, 2006
There are lots of ways to receive income, and lots of ways to spend it. In this EconomicsMinute you will develop two budgets, or plans, to help you decide how to allocate your income. Assuming you do not love making dollar bill rings.
Income is what gets you stuff, but how do you get income? Do you earn an allowance? Do you baby-sit? Do you mow lawns? Do you receive income as a gift? And once you have the income, what do you do with it? Do you run out and get rid of it all immediately? Do you spend some now and some later? Or do you save it all?
There are lots of ways to receive income, and lots of ways to spend it. In this <>EconomicsMinute you will develop two budgets, or plans, to help you decide how to allocate your income. Assuming you do not love making dollar bill rings, there are really only two things that someone like you can do with your income: spend it or save it. Spending occurs when you use your income to purchase good and services.
When you do not spend your income, you save it. You have several options when saving income. One option is to simply put it aside at home and not spend it. Another option is to deposit the money in a savings account at the bank. Why would you want to put your money in the bank? What does the bank have that your piggy bank does not? When you place money in the bank you earn interest on it. Interest is what you receive for allowing the bank to use your money. The bank pays interest because it wants to encourage people to put money in its accounts. If the bank did not pay interest to depositors, people would just keep their money in their piggy banks. Because interest is expressed as a rate, how much interest you get depends on how much money you put in the bank. The more income you save, the more interest you can expect to receive.
Below, you will find two simple budgets. The first budget assumes that you do not have a savings account. By contrast, the second budget presumes that you have opened a savings account. A budget is a plan to help you figure out what you should do with your income. What part of your income should you spend and what part should you save? What should you spend your income on?
In economics the cost of something is the value the next-best forgone alternative. This cost is referred to as opportunity cost. The highest valued alternative as a result of making a choice is its opportunity cost.
Budget #1 (no savings account)
Let's say you have five dollars. What would you like to spend it on? There are a million things you would love to use your five bucks for, but let's say there are only four things out there that you really want to buy: arcade games, gum, soda, and movie tickets. Look at the price chart in the worksheet and answer the questions that follow.
- In terms of gum, what is the opportunity cost of two sodas, assuming that the gum is your next-best alternative? [In order to get two sodas, you give up four pieces of gum.]
- In terms of soda, what is the opportunity cost of a movie ticket, assuming that purchasing soda is your next-best alternative? [In order to get one movie ticket, you give up five sodas.]
Budget #2 (with a savings account)
Of course you do not have to spend all of your money. You can save some of your money in your bank account. Let's say you put half of your money, $2.50, into the bank. However, you still would like to buy the same four goods at the same four prices. Fill out the following worksheet.
- Assuming soda and gum are your next best alternatives, what is the opportunity cost of putting $2.50 in the bank? [Answers will vary. Any combination of gum and soda that costs $2.50 works.]
If the bank pays 10 percent interest, how much interest will you earn on your $2.50 deposit? [$0.25= 2.50 x 0.10
- interest earned = balance in account x interest rate.]
- With interest your $2.50 is now worth $2.75. In terms of soda, gum, and arcade games what can you buy for $2.75? [Answers will vary. The answers will be similar to those given for Question 1, except now the students will be able to purchase one additional arcade game.]
- So, if you spend the $2.50 instead of putting it into the interest-bearing account what do you have to give up? What's the new opportunity cost of the $2.50? [By spending the money instead of putting it in the bank, you give up not only the $2.50 but the $2.50 plus any interest you will earn on that money. In terms of the example, the new opportunity cost of the $2.50 includes an additional arcade game.]
- Compare Budget #1 and Budget #2. How have the budgets changed? Why did you change your mind? [Answers will vary. Because in Budget #2 students earn interest on their money, they probably put more in savings.]