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!