EC - Tutorial 2 Savings, Investment and the Interest Rate - Justin Doran
2 What is the relationship between the world interest rate and national savings from ECON b at University of California, Berkeley. There are no closed economies. Even autarkies aren't closed economies in practice. I dislike theorizing about toy economies, because it's like arguing about . See how the rate of interest in an economy helps coordinate between savings, lending and investment. See how this changes an economy's.
Well, you could view this as national savings.
Relationship between the interest rate and saving ratio
And we see here this identity that national savings, which is often denoted with a capital S, is equal to investment. And if that isn't intuitive for you at first, just think about it at a kind of human scale. If I am saving things and I am putting it into a bank, that bank will then lend that money that can be used for investment. And we can break this down even more if we wanna think about taxes.
So let's just say T is equal to taxes. So let's just think about the private economy first. So if we think about the national income minus consumption spending, and then folks have got to pay their taxes. And then where do those taxes go? Well, they go to the government, so they stay in the economy. So notice, I'm not changing this equation, I'm just subtracting taxes and then adding taxes. And then I subtract from that government spending.
These two equations are equivalent and this is going to be equal to our investment in our closed economy. Now, if you look at this left-hand side right over here, you could view this as private savings.
This is the national income, minus how much is being consumed, minus how much is being paid to the government. So this is private, private savings.
Blog Closed Economy - Impact of Fiscal Policy on the Interest Rate Because the interest rate is the cost of borrowing and the return to lending in the financial market, we can better understand the role of the interest rate in the economy by thinking about the financial markets. To do this we rearrange the national income accounts identity as: This can be referred to as national savings or simply savings S. In this form the national income account identity shows that savings equals investment.
We can distinguish between savings in the private sector and savings in the public sector through the introduction of our tax identities. This allows the previous identity to be rewritten as: The term T — G is government revenue minus government spending, which is public savings. If government spending exceeds government revenue, the government runs a budget deficit, and public savings is negative.
National savings is the sum of both private and public savings. This equation states that the flow into the financial markets public and private savings must equal the flows out of the financial markets investment.
To see how the interest rate affects this system and brings the financial markets into equilibrium we substitute the consumption function and the investment function into the national income accounts identity.
The left hand side of this equation shows that national savings depends on income Y and fiscal policy G and T.
For fixed values of Y, T and G, national savings is also fixed. The right hand side shows that investment depends on the interest rate. For simplicity, we will use the previous assumption that saving is fixed i. This results in a vertical savings line as regardless of the interest rate there will be no change in the quantity saved.
The investment function slopes downward as the higher the interest rate the fewer investment projects are profitable. The diagram resembles a supply and demand diagram. Indeed we can think of the good being demanded as loanable funds and the price being the interest rate.
Relationship between the interest rate and saving ratio | Economics Help
Savings is the supply of loanable funds. Investment is the demand for loanable funds. The interest rate adjusts to bring savings and investment into balance. The vertical line represents savings — the supply of loanable funds.
The downward sloping line represents investment — the demand for loanable funds. The interaction of these two curves determines the equilibrium interest rate.
National savings and investment
We can now use this framework to consider what happens when various elements of the national income accounting framework change. We will now use our model to show how fiscal policy affects the economy.
But since total output is fixed, the increase in government purchases must be met by a decrease in some other category of demand.