The Financial System II

The Macroeconomics of Saving and Investment

As we have seen in the previous post Opens in new window, the funds available to firms through the financial system come from saving.

When firms use funds to purchase machinery, factories and office buildings they are engaging in investment Opens in new window.

In this post we explore the macroeconomics of saving and investment. A key point we will develop is that:

the total value of saving in the economy must equal the total value of investment.

National income accounting refers to the methods the ABS Opens in new window uses to keep track of total production and total income in the economy.

We can use some relationships from national income accounting to understand why total saving must equal total investment.

We begin with the relationship between GDP and its components, consumption (C ), investment (I ), government purchases (G ) and net exports (NX ):

• Y = C + I + G + NX

Remember that GDP Opens in new window is a measure of both total production in the economy and total income (Y ).

In an open economy there is interaction with other economies in terms of both trading of goods and services and borrowing and lending.

Nearly all economies today are open economies, although they vary significantly in the extent of their openness.

In a closed economy there is no trading or borrowing and lending with other economies.

For simplicity, we will develop the relationship between saving and investment for a closed economy. This allows us to focus on the most important points in a simpler framework.

If we rearrange this relationship, we obtain an expression for investment in terms of the other variables:

• I = Y – C – G

This expression tells us that in a closed economy investment spending is equal to total income minus consumption spending and minus government purchases.

We can also derive an expression for total saving.
• Private saving is equal to what households retain of their income after purchasing goods and services (C ) and paying taxes (T ).
• Here taxes refers to net taxes, which are equal to taxes paid minus transfer payments received.

Recall that transfer payments to households include social security payments and unemployment benefits. Households receive income for supplying the factors of production to firms.

This portion of household income is equal to Y. We can write an expression for private saving (Sprivate):

• Sprivate = Y – C – T

The government also engages in saving.

Public saving (Spublic) equals the amount of net tax revenue the government retains after paying for government purchases:

• Spublic = T – G

So total saving in the economy (S) is equal to the sum of private saving and public saving:

• S = Sprivate + Spublic

or,

• S = (Y – C – T ) + (T – G)

or,

• S = Y – C – G

The right-hand side of this expression is identical to the expression we derived earlier for investment spending. So we can conclude that total saving must equal total investment:

• S = I
• When the government spends the same amount that it collects in taxes there is a balanced budget.
• When the government spends more than it collects in taxes there is a budget deficit.

In the case of a deficit, T is less than G, which means that public saving is negative. Negative saving is also known as dissaving.

How can public saving be negative?

When the federal government runs a budget deficit, the Reserve Bank of Australia sells government financial securities such as bonds to borrow the money necessary to fund the gap between taxes and spending.

In this case, rather than adding to the total amount of saving available to be borrowed for investment spending, the government is subtracting from it.

(Note that if households borrow more than they save the total amount of saving will also fall.) With less saving, investment must also be lower.

We can conclude that, holding all other factors constant, there is a lower level of investment spending in the economy when there is a budget deficit than when there is a balanced budget.

When government spending is less than its net taxes there is a budget surplus.

A budget surplus increases public saving and the total level of saving in the economy. A higher level of saving results in a higher level of investment spending.

Therefore, holding all other factors constant, there is a higher level of investment spending in the economy when there is a budget surplus than when there is a balanced budget.

The Australian federal government has experienced dramatic changes in the state of its budget over the past 18 years.

• In 1966 the federal budget deficit was \$5 billion, which, together with pre-existing debts from previous budget deficits, meant that federal government net debt totaled \$96 billion.
• In 1997 there was a budget surplus of \$2.6 billion.
• The surplus was more than \$17 billion by 2007.

The surpluses were used to pay back previous borrowings and by 2006 the \$96 billion debt had been fully repaid and the federal government was, for a short time, a net saver, making it one of the few governments in the world to be a net saver.

By 2008, the federal government had again begun to spend more than it received in taxation revenue, operating budget deficits in an attempt to stimulate the economy during the GFC Opens in new window.

The deficit peaked at over \$54 billion in 2010, with deficits continuing for years even after the main effects of the GFC Opens in new window were over.