Explain the link between saving, investment and economic growth, and consider the factors that influence the amount of saving individuals undertake.

Table 1  Ratios to GDP of gross domestic investment and gross national saving (%)

Source: Robert J.Barro, Xavier Sala-I-Martin, Economic Growth

Moreover, 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” identity. “Most of the time, mismatches between those desired levels are brought into line fairly easily through the interest-rate mechanism.” 

Graph 4  Global saving and investment as % of world GDP

Source: International Monetary Fund

Before 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. 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.” 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 growth

Higher 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 capital. 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.

Graph 6  Original condition        Graph 7  Change in saving

         

Source: Jonathan Bradley, presentation

Even though the current consumption is now lower than before, the new point B on production possibility frontier offers higher level of expansion of this curve and it means higher level of economic growth. Graph 8 with attached table suggests presumable future development.

Graph 8  The effect of initial increase in saving on economic growth

Source: Jonathan Bradley, presentation

In reality however such a straightforward link between saving, investment and economic growth is rather a concept than exact model. Despite the empirical studies pointing out strong links between the amount of investment made in an economy and the rate of economic growth, the investment causing suggested increase in economic growth has to be usually of decent amount of money, being continuing and aiming to the right industry. In some cases despite the more affordable loans (because of an increase in saving) the firms do not have the right incentive to invest. The fall in consumption simply force them to produce less. This means that extra aggregate saving is not matched by extra aggregate investment in economic capacity. The phenomenon of higher saving leading to lower national income through lower investment is known as the “paradox of thrift” and was shown by Keynes.

 

Moreover with economic capital “saturation” the same increase in capital raises a diminishing increase in product. Then the accumulation of capital should focus rather on research and development (R&D). In history there have been many economic growth theories suggesting different mathematical functions and approaches. But most of them were forgotten because of lack of empirical relevance. Nevertheless in the latest ones the role of investment plays major role as described above.

The attention should be also concentrating on the mutual influence between economic growth and investment (saving). Even though there is a strong positive correlation between gross investment to GDP with the growth rate, timing evidence suggests that much of this association may reflect the reverse impact of growth prospects on the attractiveness of investment. Similarly Coe and Helpman (1993) found correlation between investment in R&D and economic growth. The direction of causation between them has, however, not yet been established. What is undoubtedly true though is that at the beginning of every economic growth must have been investment covered by someone’s saving.

We can go now further and try to look at the determinants that influence the amount of saving individuals undertake. Let s(Ω) be the function of “x” variables that represents the fraction of individual’s disposable income that is saved. We would find that s(Ω) is such a complicated function that it has no closed-form solutions due to the mostly indefinite variables “Ω”. But we can still at least come nearer to the solution.

The first determinant is undoubtedly income. According to J.M.Keynes, rise in income (Y) evokes the lesser proportionate rise in consumption. Graph 9 relates desired consumption to disposable income by using the hypothetical data. Its slope, ΔC/ΔY (the marginal propensity to consume) is with increasing income less steeper. By “income” we understand “real and disposable” one because taxation could significantly reduce gross income and consequently consumption and saving as well. Note that the level of autonomous consumption is at point A where all income is used for consumption. On the right from this point people create savings. On the left from point A borrowing takes place.

Graph 9  Consumption function (example)

Source: Robert Holman, Economics

Need to say that consumption function tends to shift upwards when the interest rate decreases and vice versa. Keynes’s concept could be also used for explaining another determinant which is private wealth. People with greater wealth (e.g. real estates, equities) tend to shift their consumption upwards compared to people to those with “basic” wealth. Capital gain from this wealth plays also its role. People feel richer in times of increasing capital gain around their country and spend more. The reverse effect has economic growth especially in poorer countries saving rates raise as economies grow. “This is probably because people do not adjust their consumption patterns as quickly as their income rises.” 

The second significant theory proposes the influence of stage of life. Author of so-called “life-cycle hypothesis” Franco Modigliani based his studies on the simple idea that people save for their own retirement and that they therefore accumulate savings during their active years to be able to consume those savings during their retirement. One can notice that this theory is partly connected to the consumption function. In the example (Graph 10) is visible that people have to be net borrowers up to the point A and then they start to save.

Graph 10  Life-cycle hypothesis (example)

Source: Robert Holman, Economics

Another determinant could be seen in capital taxation. If the investment returns to saving are subject to high taxation, peoples' willingness to save is in most cases reducing. On the other hand higher taxation could under certain circumstances encourage people to save more due to their target level of savings. Then we should highlight one of the most unpredictable variable in our function s(Ω) and it is the importance of precautionary reasons and expectations towards the future. People simply save for rainy days. They do not receive fix salary or their job is unstable. They can expect tough future for more or less whatever reason. People with children can have also incentive to save for their children.

Probably the last of major determinants could be found in financial system itself. As Howells points out as a financial system becomes more developed (e.g. through expansion of banking system or developing of new liquid assets) people find it easier to borrow and their saving ratio is falling. This is probably the reason why America has lower saving rate compared to world average.

In conclusion one should call the reader’s attention that the subject of linkage between saving, investment and economic growth is much more complex and explaining the issue properly would be matter of survey that go far beyond the scope of this paper. Nonetheless, to summarize we can come to the general conclusion that changes in variables of function s(Ω) represented by people’s willingness to save lead to shifts of the supply side on the market for loanable funds causing changes in real interest rates. Those changes encourage (or discourage) investor’s determination to realize their plans and through increase in productivity per worker are the subject of faster economic growth which has another reflexive effect on household’s saving.

BIBLIOGRAPHY

Textbooks:

• Julius Gould & William L. Kolb, A Dictionary of the Social Sciences, Travistock Publications, 1964
• Robert J. Barro & Xavier Sala-I-Martin, Economic Growth, McGraw-Hill Inc., 1995
• W. W. Rostow, Economic Growth, Cambridge University Press, 1971 (Second edition)
• Robert Holman, Economics, C.H.Beck, 2002 (Third edition)
• John Sloman, Economics, Prentice Hall, 2003 (Fifth edition)
• K. Alec Chrystal and Richard G. Lipsey, Economics for Business and Management, Oxford University Press Inc., 1997
• Peter Howells & Keith Bain, Financial Markets and Institutions, Prentice Hall (Pearson Education), 2004 (Fourth edition)
• Lars Oxelheim, Financial Markets in Transition: Globalisation, Investment and Economic Growth, Routledge, 1996

Journals:

• The Economist, September 24th 2005

Internet Resources:

• http://nobelprize.org/economics/laureates/1985/modigliani-autobio.html
• http://online.uwe.ac.uk/webapps/portal/frameset.jsp?tab=courses&url=/bin/common/course.pl?course_id=_53539_1
• http://www.econ.yale.edu/growth_pdf/cdp799.pdf
• http://www.house.gov/jec/fiscal/tx-grwth/capgain/capgain.pdf
• http://www.imf.org/external/pubs/ft/weo/2005/02/pdf/chapter2.pdf
• http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_oct05/recent_trends.html
• http://www.treasury.govt.nz/workingpapers/2001/01-32.asp
• http://www.unescap.org/drpad/publication/journal_8_1/PETER.PDF
• http://www-groups.dcs.st-and.ac.uk/~history/Mathematicians/Keynes.html

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