Chapter 4

Saving and
Investment
in Closed and
Open Economies
 National Saving

• National saving is the sum of private saving and

government saving:

S Y C G
• National saving rate:

S /Y

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 Saving

• Consumption expenditure:

C  C  C(Y  T , r )
+ -
where
C = autonomous consumption
Y-T = disposable income

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 Saving (cont’d)

• Assume the following variables as exogenous:

G G
T T
K K
LL

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 Saving (cont’d)

• Long-run aggregate output becomes:

Y  F (K, L )  Y
• And so desired saving becomes:

S  Y  C  C(Y  T , r )  G

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 Investment

• As real interest rates fall, households and firms are

more likely to make investments, and so the desired
level of investment in the economy will rise
• The investment function:

I  I  I(r )
—
where I = autonomous investment

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 FIGURE 4.5 The Saving-Investment
Diagram: Equilibrium in the Goods Market

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 Goods Market Equilibrium

• In the saving-investment diagram, r* keeps the

goods market in equilibrium
• If r>r*, then desired investment is less than
desired saving
• If r<r*, then desired investment is greater than
desired saving

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 Response to Changes in Saving and
Investment in a Closed Economy

• We will look at how the economy respond to

changes in saving and investment through:
1. Changes in Autonomous consumption
2. Changes in Fiscal Policy
3. Changes in Autonomous Investment

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 Changes in Saving: Autonomous
Consumption

• A rise in autonomous consumption causes saving

and investment to fall and the real interest rate to
rise in the long run, while a fall in autonomous
consumption causes saving and investment to rise
and the real interest rate to fall

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 FIGURE 4.6 Response to Change in
Saving (a)

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 FIGURE 4.6 Response to Change in
Saving (b)

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 Changes in Saving: Effects of Fiscal
Policy

• Changes in taxes
– A rise in taxes causes saving and investment to
rise and the real interest rate to fall in the long
run, while a fall in taxes causes saving and
investment to fall and the real interest rate to
rise

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 Changes in Saving: Effects of Fiscal
Policy (cont’d)

• Changes in government purchases

– A rise in government spending causes saving and
investment to fall and the real interest rate to rise in the
long run, while a decline in government spending causes
saving and investment to rise and the real interest rate to
fall

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 Changes in Saving: Effects of Fiscal
Policy (cont’d)

• Changes in government saving

– Increases in government budget deficits
(government dissaving) cause saving and
investment to fall in the long run and real
interest rates to rise

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 Policy and Practice: Crowding Out and
the Debate Over the 2009 Fiscal Stimulus
Package
• In 2009, the Obama administration proposed and
Congress passed a $787 billion fiscal stimulus
package to promote economic recovery from the
recession that started in 2007
• Although this fiscal stimulus package had potential
benefits in terms of increasing employment and
output, huge government budget deficits and
government dissaving would generate a leftward
shift of the saving curve, which would lead in the
long run to a crowding out of investment and
higher real interest rates

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 Changes in Autonomous Investment

• Changes in I causes the investment curve to

shift, which leads to a change in equilibrium
real interest rate
– An increase in business optimism or a change in the
tax code that increases autonomous investment
causes saving, investment, and the real interest rate
to rise
– When businesses become more pessimistic or the
government raises taxes on investment, lowering
autonomous investment, the investment curve will
shift to the left, and so saving, investment, and the
real interest rate will fall

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 FIGURE 4.7 Response to a Rise in
Investment

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 Saving, Investment, and Goods Market
Equilibrium in an Open Economy

• Open economies are open to trade (NX≠0) and

flows of capital across their borders
• With perfect capital mobility, the domestic interest
rate (r) must be the same as the world interest
rate (rw):

w
r r

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 Saving, Investment, and Goods Market
Equilibrium in an Open Economy (cont’d)

• Goods market equilibrium occurs when:

Y  C  I  G  NX
• Saving can be obtained by subtracting C and G
from both sides:

S = Y C I G
= I  NX
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 Saving, Investment, and Goods Market
Equilibrium in an Open Economy (cont’d)

• The goods market equilibrium condition for an open

economy is therefore:

NX = S  I

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 Saving, Investment, and the Trade
Balance in a Small Open Economy

• A small open economy is open to trade

and to flows of capital across its borders
that is “small” relative to the world
economy, meaning that we take the world
real interest rate (rw) as given
• Large open economies (e.g., the United
States) are sufficiently large that saving
and investment decisions do influence the
world real interest rate

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 Goods Market Equilibrium in a Small
Open Economy

• Open economy equilibrium occurs when S–I

= NX
• If the world interest rate is greater than the
real interest rate if the economy were
closed (i.e., rw>rE), then:
– the value of net exports is positive (trade
surplus)
– there is a net capital outflow as S>I

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 Goods Market Equilibrium in a Small
Open Economy (cont’d)

• If the world interest rate is less than the

real interest rate if the economy were
closed (i.e., rw<rE), then:
– the value of net exports is negative (trade
deficit)
– there is a net capital inflow as S<I

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 FIGURE 4.8 Saving-Investment
Diagram in a Small Open Economy

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 Connection Between the World
Economy and Small Open Economy

• Increases in world saving (from a decline in

world autonomous consumption
expenditure, an increase in world taxes, or
a decline in government spending
throughout the world) or decreases in world
investment cause the domestic real interest
rate to fall, domestic investment to rise,
and net capital outflows (net exports) to fall
giảm auto C
--> Tăng Sw
Tăng Tw
Giảm G

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 Response to Changes in Saving and
Investment in a Small Open Economy

• Changes in domestic saving

– An increase in saving in the small open economy
(from a decrease in autonomous consumption
expenditure or a rise in government saving from a
rise in taxes, or a decline in government spending)
leads to a higher trade balance (increase in the trade
surplus or a shrinkage of the trade deficit) and an
increase in net capital outflows
– A decrease in saving leads to a decline in the trade
balance (a shrinkage in the trade surplus or an
increase in the trade deficit) and a decrease in net
capital outflows

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 FIGURE 4.9 Response to a Rise in
Saving in a Small Open Economy

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 Application: The Twin Deficits

• From 1979 to 1983, U.S. government saving

declined sharply because the budget deficit for
the combined government (federal, state and
local) went from under 2% of GDP to nearly
6% of GDP
• Meanwhile, the U.S. economy began to display
a large trade deficit
• The saving-income analysis explains why this
twin deficits (simultaneous trade deficit and
government budget deficit) occurred

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 FIGURE 4.10 The Twin Deficits,
1970-2013

Source: Federal Reserve Bank of St. Louis, FRED Database. http://research.stlouisfed.org/fred2/

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 Response to Changes in Saving and
Investment in a Small Open Economy
(cont’d)

• Changes in investment
– An increase in autonomous investment causes a decline in
the trade balance (the trade surplus to shrink or the trade
deficit to increase) and lowers net capital outflows

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 FIGURE 4.11 Response to a Rise in
Investment in a Small Open Economy

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 Application: #1

Suppose Japan has a GDP of 5 trillion, and that its

national savings rate is 25%.
•Calculate Japan’s national saving
•Calculate Japan’s government saving if private
saving is $800 billion

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 Application: #2

In the United Kingdom in 2010 David Cameron

became Prime Minister leading a new coalition
government that immediately announced public
spending cuts aimed at reducing government budget
deficit. Supposing that these cuts were successful.
How would you analyze them using a graph (assume
the U.K were a closed economy).

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 Application: #3

Suppose Japan has a GDP of 5 trillion, and that its

national savings rate is 25%. Assuming Japan is an
open economy
•Calculate Japan’s investment if net exports are 1%
of GDP
•Calculate Japan’s exports if imports are valued at
$650 billion

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 Application: #4

Consider the following diagram of a small open economy:

•Calculate net exports and capital outflow when the world real interest
rate is 7%
•Calculate net exports and capital outflow when the world real interest
rate is 5%

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 Application: #5

Consider a small open economy that is currently

running a trade surplus. Answer the following
questions using a graphical representation of desired
saving and investment in the small open economy:
•Is the world real interest rate higher or lower than
the real interest rate that would prevail if this were a
closed economy
•What would be the effect of an autonomous
decrease in investment on the trade balance.

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