Lesson 6ª


 

 

 

 

 

   
  RELATIONSHIP BETWEEN SAVINGS AND INVESTMENT

The amount of savings a country has is fundamental to finance new investments that the country may wish to undertake. Savings are also important as they benefit the economy and in the long term, help to give a higher level of life.

One part of a country's income goes to consumption and another part goes to savings. There is a direct relationship between savings and investment.

In every economy:

Savings = Investment

Therefore, for a company to invest more, it should consume less and save a greater part of its income.

We are going to try and explain why there is this equality (Savings = Investment) (Let's see if we can!).

To simplify the explanation, lets suppose that we are talking about a country that doesn't have foreign trade (they don't export and don't import), their GDP is defined by:

Y = C + I + G

Where: Y (GDP), C (Consumption), I (Inversment), G (Governement Spending).

If we clear investment, we have:

I = Y - C - G (Equation 1)

On the other hand, the income generated will be destined to a part of the savings (S) and another part to the consumption (both private "C", as public"G"):

Y = S + C + G

If we clear the savings (S) we have:

S = Y - C - G (Equation 2)

Now relating equation 1 with equation 2 we have:

I = S

Then, we have demonstrated (yes we have demonstrated) that saving is the same as investment.

Economy with foreign sector

The relationship which we have just explained (S = I) is also fulfilled when you consider the foreign sector. In this case:

Y = C + I + G + NX

Where (NX) is the net position of international trade (exports-imports)

If we use the equation we have:

Y - C - G = I + NX

On the other hand, we have already seen that savings can be expressed:

S = Y - C - G

Then, we can conclude that:

S = I + NX

On the other hand, the net position of international trade (NX) is equal to the foreign direct investment (FDI). People often ask "why?". We are going to try and explain why with the following example:

Lets suppose that Spain has a business surplus con Japan (NX > 0)

The Spanish export companies will go to the Bank of Spain to change their yens for euros, which will produce an increase in the deposit of yens. Therefore, Spain will increase its posession of Japanese assets (the yen is a Japanese asset), therefore Spain increases its foreign direct investment (in the same amount as the business surplus).

Therefore:

S = I + FDI

That's to say, that savings is the same as domestic investment plus foreign direct investment.

If Spain saves a determined quantity, this will finance either the domestic investment or foreign investment.

Before we end this lesson, we want to apologize for the "bomb" we have just dropped. Please take a half an hour break and get some fresh air!