Macroeconomics: Policy And Practice 2 Chapter 4

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Chapter 4

Saving and Investment in Closed and Open Economies

◼ Chapter Outline, Overview, and Teaching Tips

Chapter Outline

Relationship Between Savings and Wealth

Private Saving

Government Saving

National Saving

Policy and Practice: Government Policies to Stimulate Saving

Uses of Saving

The Link Between Saving and Wealth

Macroeconomics in the News: Balance of Payments Accounts

Application: How the United States Became the Largest Net Debtor in the World

Saving, Investment, and Goods Market Equilibrium in a Closed Economy

Saving and Investment Equation

Saving

Investment

Goods Market Equilibrium

Response to Changes in Saving and Investment in a Closed Economy

Changes in Saving: Autonomous Consumption

Changes in Saving: Effects of Fiscal Policy

Policy and Practice: Crowding Out and the Debate Over the 2009 Fiscal Stimulus Package

Changes in Autonomous Investment

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

Perfect Capital Mobility and the Open Economy

Goods Market Equilibrium in an Open Economy

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

Goods Market Equilibrium in a Small Open Economy

Connection Between the World Economy and Small Open Economy

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

Changes in Domestic Saving

Application: The Twin Deficits

Changes in Investment

Chapter 4 Saving and Investment in Closed and Open Economies 33

Large Versus Small Open Economies

Chapter 4 Web Appendix: Saving and Investment in Large Open Economies

Chapter Overview and Teaching Tips

This chapter discusses the relationship of saving and investment and its impact on the economy. A key point

to make to students is that the analysis here is a long-run context in which wages and prices are flexible

and so the economy is at full employment. A unique feature of this chapter relative to many other textbooks

is that it covers both closed and open economies in one chapter. I believe this is important because the

impact of saving and investment on the economy needs to be thought of not only in a domestic context,

34 Mishkin • Macroeconomics: Policy and Practice, Second Edition

1. The two components of national saving (S) are private saving (SP) and government saving (SG). Private

saving is disposable income (YD, which is GDP or national income Y minus taxes T) minus consumption

expenditure (C). Government saving is taxes minus government purchases (G). Thus, national saving

2. Desired national saving is positively related to income, the real interest rate, and taxes and inversely

related to consumption and government purchases. Desired investment is positively related to the

additional profits the investment is expected to generate and inversely related to the real interest rate.

In a closed economy, goods market equilibrium requires the amounts of desired saving and

investment to be equal. This balance between desired saving and investment comes about through

4. Crowding out refers to the decrease in investment spending that results because government spending

increases. This occurs because an increase in government spending reduces desired saving and causes

Chapter 4 Saving and Investment in Closed and Open Economies 35

5. A closed economy has no interactions with other economies. Therefore, its net exports and net capital

outflow both equal zero. An open economy does engage in international trade and is open to outflows

6. The world real interest rate is the rate that equates desired world saving and desired world investment

and thus achieves goods market equilibrium for the world as a whole. If an individual country’s

equilibrium real interest rate (r) is not the same as the world real interest rate (rw), perfect capital

7. Both types of economies are open to trade and capital flows, but the “small” economy is so small

8. The small open economy will have a trade surplus if the world real interest rate is above rE, the real

interest rate at which the small open economy’s desired amounts of saving and investment would be

the same. (rE would be the equilibrium real interest rate if the economy were closed.) At the higher

9. Unlike a closed economy where an increase in desired saving would lower the domestic real interest

10. An increase in domestic saving shifts the saving curve to the right; as a result, the trade balance and

11. A large open economy has characteristics of both closed and small open economies. It responds like a

small open economy in the way that given changes in domestic saving and investment affect the trade

balance and net capital flows. It responds the way a closed economy does regarding the effect those

36 Mishkin • Macroeconomics: Policy and Practice, Second Edition

= $1.25 trillion.

2. a. If you buy a newly built home, you will add to the economy’s residential investment, therefore

adding to the investment spending component of GDP. If you buy a U.S. savings bond, you will

be transferring funds to the U.S. government, but that action will not add to the economy’s capital

stock (the U.S. government might use these funds to build roads, which would be considered

3. If workers realize that they will not have a safety net when they retire, they might start saving more

now. This is the case in many other countries in which a social security system either does not exist

Chapter 4 Saving and Investment in Closed and Open Economies 37

Everything else the same, a decrease in the government deficit means that national saving will

6. a. Considering Japan an open economy means that Japan’s investment equals its national saving

minus its net exports. If saving is $1.25 trillion (25 percent of $5 trillion) and net exports equal

38 Mishkin • Macroeconomics: Policy and Practice, Second Edition

a. When the world real interest rate is 7 percent, desired saving exceeds desired investment by $400

a. If this country is running a trade surplus, this means that the world real interest rate is such that

9. a. A decrease in autonomous investment decreases desired investment at each real interest rate and,

therefore, shifts the investment curve to the left. In a closed economy, this results in a decrease in

the equilibrium real interest rate and investment and saving levels. The economy’s wealth will

eventually decrease, as the economy’s addition to its capital stock decreases.

Chapter 4 Saving and Investment in Closed and Open Economies 39

10. a. For a large open economy, an increase in government surplus increases desired saving at every

real interest rate. The saving curve shifts to the right, increasing net exports. The domestic real

interest rate decreases because the large open economy can affect the world real interest rate.

1. a. GPSAVE was 2,138.9 billion in 2008:Q1, and 2,752.2 billion in 2013:Q1. GSAVE was 2,010.1

billion in 2008:Q1 and 2,232.3 billion in 2013:Q1. Thus, gross private saving increased by 613.3

2. a. For 2013:Q1, net exports = 559.018 – 682.676 billion = –123.658 billion. This represents a trade

3. a. From 2005:Q1 to 2013:Q1 government saving decreased from –19.9 billion to –519.9 billion, a

decrease of 500 billion. This is due to persistently large budget deficits that grew rapidly during

and after the Great Recession of 2008–09 but have moderated in recent years.

b. The decline in government saving of 500 billion, holding all other factors constant, should shift

the savings curve to the left, resulting in higher equilibrium real interest rates in the United

1. Goods market equilibrium requires that world saving equal desired world investment, which means

that a trade surplus (or deficit) in the domestic economy must equal the trade deficit (or surplus) in

40 Mishkin • Macroeconomics: Policy and Practice, Second Edition

3. A fall in domestic saving decreases the domestic economy’s trade surplus and its net capital outflow

4. When the interest rate is 7 percent, net exports are $90 billion, which equals the amount of funds that

domestic residents want to lend to the rest of the world. When the interest rate is 5 percent and 3

5. A decrease in government expenditures in the domestic economy results in an increase in domestic

saving, shifting the saving curve to the right. At a world interest rate of 4 percent, the trade deficit

6. A decrease in autonomous domestic investment shifts the investment curve to the left and increases

the trade surplus at every given world interest rate. This will increase the amount of funds that U.S.

residents want to lend to the rest of the world. As a result, the world interest rate decreases from

Chapter 4 Saving and Investment in Closed and Open Economies 41

◼ Data Sources, Related Articles, and Discussion Questions

A. For Information About Policy and Practice: Government Policies to

Stimulate Saving

Data Source

Federal Reserve Bank of St. Louis database: http://research.stlouisfed.org/fred2/categories/112. Here you

can find the latest data on saving and investment indicators in the United States (by clicking on a series

name, you can get a graphic representation immediately).

Ehrbar, Al, “Consumption Tax”: http://www.econlib.org/library/Enc/ConsumptionTax.html. This article

discusses the implications of capital income taxation. It refers to the 2003 tax bill that reduced the top tax

rate on dividends and capital gains.

Discussion Question

Suppose you are a policymaker and your goal is to increase national savings. Everything else the same, do

you think that a budget deficit reduction is the best way to achieve your goal? Explain.

42 Mishkin • Macroeconomics: Policy and Practice, Second Edition

Chapter 4 Saving and Investment in Closed and Open Economies 43

44 Mishkin • Macroeconomics: Policy and Practice, Second Edition