SAVING AND INVESTMENT

Aggregate demand (Y^d ), or aggregate production, consists of consumer demand (C), domestic investment demand ( I^DOM ), government demand (G), and net export demand (EX - IM):

(1.0)

Y^d = C + I^DOM + G + (EX - IM)

Aggregate supply (Y^s ) consists of a nation of individual incomes for which it is true that for each "either you spend it, it gets taxed, or you save it.":

(2.0)

Y^s = C + S^PVT + T

where S^PVT is private saving and T is net taxes -- gross taxes minus transfer payments such as welfare, unemployment compensation, and social security pensions.

Aggregate supply is aggregate income with which to buy output and is usually called national income. In equilibrium, aggregate demand will equal aggregate supply, so that the superscripts d and s can be omitted:

Y^d = Y^s = Y

Types of Saving and Investment

As an initial simplifying assumption, assume that net unilateral transfers in the balance of payments are approximately zero. Then, if EX - IM represents net exports of all kinds -- goods, services, and investment income, the current account balance will be EX - IM. Also, "saving" in general terms is income - expenditure.

From Equation (1.0):

I^DOM = Y - C - G - (EX - IM)

or,

(3.0)

I^DOM = Y - C - G - EX + IM

In a few moments, we will discover that I^DOM will be equal to a certain type of savings.

From Equation (2.0):

S^PVT = Y - C - T

There are two other forms of saving, government saving S^GOV and saving by the Rest-of-the-World S^ROW with respect to the U S:

S^GOV = T - G

T - G represents net income minus expenditure for the government.

EX - IM is our income - expenditure with respect to the ROW and IM - EX is income - expenditure for the ROW with respect to the U S:

S^ROW = IM - EX

Saving and investment include several components -- domestic saving, total saving, domestic investment, net foreign investment (NFI), and total investment. Their respective definitions are shown below:

Domestic Saving

S^DOM = S^PVT + S^GOV

Total Saving

S^TOTAL = S^PVT + S^GOV + S^ROW

Current Account Balance

EX - IM = current account balance

EX - IM = net foreign investment

EX - IM = current account surplus

Current Account Deficit

IM - EX = current account deficit

IM - EX = S^ROW

Total Investment

I^TOTAL = I^DOM + NFI

Net Foreign Investment (NFI)

EX - IM = NFI by US in ROW = Capital Outflow

IM - EX = NFI by ROW in US = Capital Inflow

Relation Between Saving and Investment

From the statements S^PVT = Y - C - T and S^GOV = T - G and S^ROW = IM - EX, we have:

S^TOTAL = (Y - C - T) + (T - G) + (IM - EX)

which simplifies to

S^TOTAL = Y - C - G - EX + IM

From equation (3.0):

I^DOM = Y - C - G - EX + IM

From this we have established the following relation between saving and investment:

(4.0)

S^TOTAL = I^DOM

It is relatively easy to show that

(5.0)

S^DOM = I^TOTAL

Domestic saving is not equal to domestic investment and total saving is not equal to total investment.

With a slight rearrangement of terms, the following statements summarize the relations between saving, investment, federal deficits, and current account deficits:

(6.0)

S^PVT = I^DOM + Government Deficit + Current Account Surplus

"Private saving goes to finance domestic investment and the government deficit and the current account surplus."

(if we export more than we import, we have to finance the difference)

(7.0)

I^DOM = S^PVT + Government Surplus + Current Account Deficit

"Domestic investment is financed by private saving and the government surplus and the current account deficit."

Looking at equation (7.0), we can say "Ceteris paribus, the bigger the current account deficit, the better it is for domestic investment." Ceteris paribus means "all else held constant," namely private saving and the government surplus held constant. Domestic investment can be regarded as the "engine of growth" for GDP. In this sense, it can be said that a large trade deficit is good rather than bad news.

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SAMPLE PROBLEMS

EXAMPLE #1

Input Data:

S^PVT = 10

current account surplus = -6

S^GOV = -8

Find the following (answers are in Column 2)

SDOM	2
ITOTAL	2
Gov Surplus	-8
Gov Def	8
NFI	-6
curr acct def	6
cap inflow	6
cap acct bal	6
cap acct surplus	6
curr acct bal	-6
SROW	6
STOTAL	8
IDOM	8

EXAMPLE #2

Input Data

S^ROW = 75

Gov Def = 150

I^TOTAL = -25

Find the following (answers are in Column 2)

SDOM	-25
IM - EX	75
Gov Surplus	-150
EX - IM	-75
NFI	-75
curr acct def	75
cap inflow	75
cap acct bal	75
cap acct surplus	75
curr acct bal	-75
curr acct surplus	--75
STOTAL	50
IDOM	50
cap outflow	-75
SGOV	-150
SPVT	125

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Page created May 26, 1998