The link between saving, investment and economic growth

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Last updated: April 19, 2019

Saving, investment and economic growth. Each of these terms are mentioned in daily news and each of these terms is commonly accepted and well-known; separately.

What most people are not aware of; however, are mutual connections between these economic indicators and this is what this paper tries to survey. The first section looks at the theoretical and empirical linkages between saving and investment followed by a section where the economic growth is taken into account. The last section covers and explains major determinants of the amount of saving individuals undertake.In order to achieve a consistent conclusion one has to take it step by step. So, let’s start with the first term – saving1. In economics “saving is treated as the foregoing of consumption to accumulate assets” and in analytical terms “everyone is agreed that saving means the excess of income over expenditure on consumption”2. Major savers have always been households and their savings then represent “loanable funds” which offer to lend.

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People however possess one feature and that is the impatience in consumption causing their preference of consuming now rather than in the future. That is the main reason why these people have to obtain interest, should they postpone their consumption. And as Graph 1 shows the higher the interest rate is the greater the household’s willingness to offer a higher proportion of their income is. The market supply of loanable funds is then the horizontal sum of individual “saving functions”.Graph 1 Individual saving function (example)These loanable funds are demanded by those who want to invest but do not have a sufficient amount of their own savings.

This demand by borrowers (mainly firms, less then government and households) is inversely related to real interest rate due to two reasons. Firstly the higher the interest rate is the lesser the willingness to invest is. Secondly, the more capital goods the firms use the lesser their marginal product is (Graph 2). The horizontal sum of individual investment functions represents the demand side of the market for loanable funds. Need to be said now that money spent on investments does not have to necessarily come from market lenders. The investment can be covered by the reinvesting of company’s profits and cash flows.Graph 2 Individual investment function (example)Thus the market governed by the real rate of interest passes the funds from the hands of those who save to those who have investment opportunities.

Graph 3 Market for loanable fundsIf we were about to follow economic principles we would come to the conclusion that the market would always find its equilibrium and savings would always equal investments. (point E on Graph 3) Not to mention the idea that people cannot save without investing their money somewhere and vice versa. Saving and investment seem to be two sides of the same coin and in statistics will always end up as equals. And indeed that is true for the world as a whole, but since capital can flow across borders it is not true for individual countries3. Table 1 indicates the time paths of domestic investment and saving are usually similar but rarely the same.

International capital movements are a kind of arbitrages on the global capital market where the capital flows from cheaper markets (with lower rate of interest) to more expensive markets (with higher rate of interest).Table 1 Ratios to GDP of gross domestic investment and gross national saving (%)Source: Robert J.Barro, Xavier Sala-I-Martin, Economic GrowthMoreover, the fact that if more money is saved there will be more available for banks and other financial institutions to lend out does not guarantee that world saving equals investment. The global difference between these two indicators shown on Graph 4 is caused by the different amount of desired saving and investment at one moment since the decisions to save and invest are made by different people – saving and investment are an “ex-post” identity4. “Most of the time, mismatches between those desired levels are brought into line fairly easily through the interest-rate mechanism.”5Graph 4 Global saving and investment as % of world GDPSource: International Monetary FundBefore evaluating the link between saving, investment and economic growth one should clarify the terms we are referring to. The expression of “investment” usually denotes the act of investing in the sense of exchanging one asset for another which is expected to produce a greater return over a longer period of time.6 In this section we used term investment as a “net investment” which is simply that part of gross investment that increases the stock of capital.

(net investment=gross investment-depreciation) The economic growth we refer to in this paper is defined as a “long-period increase in a country’s national income in real terms.”7 Commonly known as a potential growth. It is very important to distinguish between actual (real) and potential economic growth. Meanwhile the actual growth reflecting changes in aggregate demand is the percentage annual increase in national output, potential growth is the percentage annual increase in the economy’s capacity to produce and impulses for it is given by changes in aggregate supply. (see Graph 5a,b)Graph 5a Actual growth (expansion) Graph 5b Potential growthHigher potential GDP can be achieved by means of three basic ways – by exploiting so far unused natural resources, by taking part in international trade and specialisation and by accumulation of capital8. The last mentioned impulse has the vital significance for this study since the accumulation of capital cannot take place without investment.

By the accumulation of capital we understand not only the production of capital goods but also investment into research and development because the technological advance in itself requires investment. In this case the economic growth wages if the capital increases in greater scale than labour and natural resources. Accumulation of capital changes the ratios between factors of production – the ratios of capital to labour and natural resources is increasing whereby the product per worker (productivity of labour) is rising.Graphs 6,7 simulate the process of change in saving. Let’s assume closed economy producing at full capacity where national product (3000 units) can be either consumed or saved (=invested). At the beginning people are spending 2200 units of their income and the rest representing by 800 units is saved and invested at 5% rate of interest.

Now suppose that people change their saving preferences. With reference to Graph 7, decision to save more caused the shift of supply curve on the market for loanable funds to the right. This leads to a decrease in interest rate and compared to the original condition more money is now invested and less is consumed.

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