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

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

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 – saving. 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”. Major savers have always been households and their savings then represent “loanable funds” which offer to lend. 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 funds

If 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 countries. 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).

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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 ...

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