Saving and Investment
Saving and Investment
Saving and Investment
The key to thinking about how to relate these concepts together in the frame-
work of the Keynesian neo-classical synthesis is to use a number of important
distinctions. Firstly, one must distinguish between potential output Ȳ and
actual output Y. In the usual model, output can in the short run be below or
above potential output. If it is below, there is unemployment and deflation.
If it is above, there is inflation. Secondly, one must distinguish between gross
domestic product, equivalent to national output, and gross national income,
which consists of gross domestic product minus the payment of the national
external debt (interest payment paid by both government sector and private
sector to abroad) plus interest payment from abroad (again to both govern-
ment and private sectors). When an economy is closed, there is no trade in
goods. This means that there can be no borrowing or investment abroad in
order to buy foreign goods or sell domestic goods abroad. (Foreign money
is useless to domestic consumers and domestic money is useless to foreign
consumers.) This means that national income and output are the same.
1 Closed Economy
1.1 “The equality of saving and investment is a na-
tional income accounting identity.”
Imagine we have and economy that produces and capital good K and a
consumption good C. Its production function is defined as follows.
F (K, L) = Y (1)
where Y is a (K, C) bundle, and L is the labor supply. Imagine that all
of C is consumed each period and that all factors of production are used to
1
produce something each period (full employment of productive resources).
If we define saving as the factors of production that the economy does not
put towards consumption, then necessarily (since we have assumed full em-
ployment of resources) saving is equivalent to investment. All that which we
do not put towards the production consumption goes to the production of
capital.
C + I + G = cY + I + G = Y
=⇒ cY + I + G = Y (c + s + t) (2)
The government budget surplus B is:
B = tY − G
I = sY + B (3)
This identity tells us that private sector investment is equal to private sav-
ing plus government saving. A budget surplus implies government saving
because the government is raising more in tax revenue that it is spending.
2
The government must be using this surplus to pay off its debt, so it is buying
bonds and other assets from the private sector. The money it is giving to the
private sector to purchase back this government debt (or build up government
asset holdings) is either being consumed or invested. Since we have assumed
that consumption is a constant proportion of income/output, private sector
consumption will not increase despite the increase in government saving pro-
vided the economy remains at potential output so that Y remains unchanged
after the tightening of the budget. An improvment in the government budget
surplus therefore implies an increase in private sector investment, if private
sector consumption and savings and overall output remain unchanged. (This
is obvious when we consider from the perspective of aggregate supply that
the only way to make room for more I at full employment when C is fixed so
that Ȳ = C̄ + I¯ + Ḡ is to make G smaller and thus improve the government
budget surplus.)
3
neo-classical synthesis model is the level of output which would pertain if
the labour market (along with all other markets) is in equilibrium (i.e. no
“excess” unemployment). In this special case, then, the quality of savings
and investment is part of a general equilbrium in the microeconomic sense.
However, when output is away from its potential level, the equality of savings
and investment is only a partial equilibrium in the microeconomic sense. If
there is “excess” unemployment (the definition of which is fairly complex
and a topic in its own right) then savings and investment must be away from
their true general equilibrium levels (probably both too low).
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1.3 “More investment requires more saving.”
Equation 3 shows us that the only way for private sector investment to
increase is for either government savings or private savings to increase. Note
however, that this does not imply that the private sector savings rate, s,
must increase. If output increases then this increases private sector saving
and government saving. This means that in a recession, policies to stimulate
aggregate output may be the correct remedy to increase investment. On
the other hand, if the economy is at potential output Ȳ already, the only
way to increase investment Iin¯ the long run is to increase the savings rate s
or decrease government expenditure G. This is because the economy cannot
(indefinitely, at least) operate at greater than potential output.
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that more investment requires a lower rate of interest.
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from a consumption-maximizing point of view.) (Also note that although a
closed economy can only invest by spending resources on capital formation,
an open economy can sell goods abroad, thus building up stock of foreign as-
sets, opening up another avenue for investment to increase national income
over time.)
2 Open Economy
When an economy is open to external trade, a new component, net exports
NX is added to the national income identity:
Y = C + I + G + NX
Rearranging this identity using our earlier formulae for the budget deficit
and consumption C=cY gives us:
I = sY + B − N X
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as we already saw, or in greater net exports NX. If net exports increase this
implies that the economy as a whole is earning foreign currency. This must
either be being stockpiled (e.g. a lot of Asian countries have huge stockpiles of
U.S. dollars) or used to buy other foreign assets such as foreign government
bonds, equity, bank accounts, etc. Either way, the economy as a while is
increasing its stock of wealth, and will enjoy a higher national income in the
future due to the interest payments from its investment.
Within the Keynesian multiplier model, we deal with the opening of the
economy by having two new variables, autonomous exports X0 and the
marginal propensity to import out of consumed income mi . This gives us:
Y = C0 + (1 − t)mc Y + I + G + X0 − (1 − t)mc mi Y
C0 + I + G + X0
Y =
1 − (1 − t)(1 − ms )(1 − mi )