Ceslav Ciobanu
Saving and Investment in Closed and Open Economics
Introduction
Savings and investment are the foundation of long-term economic growth of any country. Investments and savings are closely related: there are no investments without savings, but not all of the savings can turn into investments. Investments are only those savings that are directly or indirectly invested in the production development for the profit in the future (Economicshelp.org, 2008).
Today's understanding of the investment comes from the fact that the investment refers to only those savings that are invested in a variety of factors of production and activities in order to extract not only profits, but also a certain social outcome. Modern investment involves not only long-term investments, but investments for any length of time needed for production and affordable for the owner of the money.
Investments may be made in any form: in the form of money, property (e.g., land or equipment). Even the intellectual property can be used as an investment - a new idea, which is transmitted for use in the production. This idea can be sold to other manufacturers for some money, and then other manufacturers will receive the benefits from its use. In this paper, we discuss how these values are associated with the international flow of goods and capital, which can be measured volumes of net exports and net foreign investment.
The Relationship between Savings and Investments
The changes in the volume and proportions of investments have an impact on the volume of production and employment, structural changes in the economy, the development of industries and sectors of the economy.By providing the accumulation of funds of enterprises, production capacity, investments have a direct impact on current and future results of operations. The use of investments is very important to the economy. The increase in the scale of the investment without a certain level of its effectiveness is not conducive to sustained economic growth. Investing in obsolete technologies and means of production also cannot have a positive economic effect. Irrational use of investment entails freezing of resources and thereby reducing the volume of production.
Investments are defined depending on the factor of economic growth. The dynamics of gross and net investment is the indicator of economical growth. Gross investment is the total volume of the invested funds allocated to fixed assets and inventories during a certain period of time. It includes expansion investments and renovation investments.
The source of the increased investment is a newly created value, net accumulation of national income funds. Entrepreneurs mobilize it from their own profits and from loan capital markets. The source of renovation investments is depreciation deductions.
Net investments represent the amount of gross investment, reduced by the amount of depreciation in a particular period (Staff, 2006). The size of the net investment (at a certain level of efficiency of their use) shows in what phase of development currently the country's economy is. If the volume of gross investment exceeds the amount of depreciation charges (positive net investment), an increase of productive capacity ensures extended reproduction, the economy is on the recovery stage, increasing business activity, and the state has a "developing economy".
In case of equality of gross investment and depreciation (net investment is equal to zero), the number of investment funds that enters the economy is equal to the level of consumption. There is a simple reproduction of the social product that is characterized by the absence of economic growth.
If the value of gross investment is less than depreciation expense (negative value of net investment), there is a reduction of investment, which causes a reduction in production capacity. As a consequence, there is an economic downturn.
Sustainable and balanced economic development is provided by the uninterrupted investment process, in which the change in the volume of net investment not only affects the income changes in the economy, but also causes a multiplier effect. This effect is that in the conditions of repeating flows of investment spending that cause repeating revenue intake, the expenditure of one subject appears to be the income of others. Any change in income at a certain ratio between consumption and savings is a corresponding change in consumption and savings. The original fluctuations in the value of investments lead to multiple changes in income (Investopedia, 2008).
Thus, the growth of investment causes an increase in the level of output and income, which breaks down into consumption and savings. The part directed to consumption (e.g. the purchase of goods) is a source of income for producers. The resulting income, in turn, breaks down into consumption and saving, etc. As a result, the initial increase in investment leads to a multiple increase in income.
The multiplier also works in the opposite direction. With a slight reduction in investment spending, a significant reduction in income may occur. Therefore, for the effective functioning of the economy, a specific value of multiplier coefficient should be provided, in order to create the conditions for trouble-free investment.
Saving and Investments in Open and Closed Economics
In this part we will discuss the mathematical relationship between saving and investments in open and closed economics. The problem of the investment and savings balance is closely related to the concept of macroeconomic equilibrium. In the most general form, equilibrium is the balance and proportionality of economical basic parameters. In other words, a situation where economic actors have no incentive to change the status quo. In relation to the market, equilibrium is a correspondence between the production of goods and effective demand for these goods (Study.com, 2016).
Usually the balance is achieved by either needs restrictions (in the markets they always appear in the form of effective demand) or by increasing and optimizing the use of resources. Let’s consider under which circumstances the equilibrium is reached in all three markets - the commodity market, money market and foreign market. The processes occurring in the foreign market are reflected on the balance of payments of the country. This market is in equilibrium when the balance on the current account and capital flow is zero. In other words, the current account balance should be equal to the balance of the capital account.
Import - export = export of capital - capital imports.
Imports of goods and services depends on the exchange rate and the value of national income in the country. The relationship between the level of the national volume of production and the volume of imports is determined by the marginal propensity to import. It shows the percentage of increase-decrease of goods and services in response to changes in national income. The volume of exports of goods and services depends on the exchange rate and the level of prices on the domestic and foreign markets (ceteris paribus). The capital flow direction (import or export) is largely determined by the real interest rate. Various interest rates in different countries will lead to the transfer of capital between them in order to increase profitability of investments.
At the heart of the classical model of savings and investment relationship is the "law of markets" or “Say’s law” that was formulated by French economist J.B. Say (Investopedia, 2010). He considered that the supply of goods creates its own demand, or in other words, the volume of products produced automatically provide an income that is equal to the value of all created commodities and therefore sufficient for its full implementation. This means that the resulting revenue is consumed in its entirety. In theory, the classics of the market mechanism itself is capable of correcting the imbalances arising from the scale of the national economy with a flexible interest, flexible wages and flexible prices. State intervention is unnecessary.
One of the major components of GDP is the consumption of the population. The part of the income, which the population does not consume, is savings. If people receive extra income, they increase consumption. This phenomenon economists call marginal (additional) propensity to consume (MPC). It is defined by the formula (Fontinelle, 2005):
,
where is the change in consumption expenditures and is the change in income.
Similarly, it is possible to determine the marginal propensity to save (MPS). It shows what part of the population uses the additional income on savings (Investopedia, 2014).
,
where is the change in savings and is the change in income.
Income growth causes an increase in both consumption and saving. The numerical values of the marginal propensity to save and the marginal propensity to consume in the sum must always equal to 1.
MPC + MPS = 1
In addition to the consumption, the most important element is investment expenditure. However, the problem of internal equilibrium does not exhaust the macroeconomic perspective, as well as macroeconomic policies. The economies of all countries come into increasingly expanding and deepening cooperation. It is an objective component of the process, called globalization.
Thus, the balanced functioning of the economy and balanced economic growth include the concept of the external balance. Hence, it is important to distinguish such concepts as closed economy and open economy.
A closed economy is an economy that is not a subject of any influence. It is not a part of international trade, consequently, it has no export or import of any kind. In this sense, a closed economy is considered as a theoretical model, which allows us to understand the mechanism of functioning of the national economy, which is the primary task of macroeconomic analysis. Studying the closed economy, we simplify the model of the circuit of national income, and focus on the analysis of income and expenditure in the national economy. In this regard, the aggregate demand in a closed economy is represented as the sum of planned consumption, investment and government spending (Kazmer & Konrad, 2004):
AD = C + I + G
However, a number of problems require the research of so-called open economies. Open economy is an economy of participating in international trade and financial relations with various countries of the world. The model of circulation of national income in an open economy takes into account the impact of the "rest of the world": export is injected into the circulation of national income.
For further analysis purposes, we recall that in accordance with the basic macroeconomic identity, the projected total cost (the aggregate demand of income) may be represented as the sum of planned consumption, investment and government spending, and net exports on costs:
AD = C + I + G +X
Exports and imports are characterized by the volume of foreign trade (foreign trade). In terms of macro-economic analysis, it is essential to the question of export and import ratio (the difference in monetary terms between which is the foreign trade balance). If for some period of time, imports exceed exports, the formula in the net export costs of the above is negative, which may cause the reduction of aggregate demand and, therefore, may be a threat to macroeconomic stability. If exports exceed imports, net export is a positive value, which increases aggregate demand. Such an increase in aggregate demand, not only contributes to the stabilization of the economy, but under certain conditions (increased investment in export industries) provides the basis for economic growth.
As it was already mentioned, the total cost of the economy is the sum of consumption spending, investment, government purchases, and net exports. Because each dollar of the costs is reflected in one of the four above components, the GDP expression for expenditures is an identity, true for all values of the variables included in it.
Recall that the national savings are funds remaining after payment of public procurement and consumption expenditure. National saving (S) is equal to:
S=Y-C-G
If we transform the original identity of the subject of this relation, we obtain:
Y — С — G = I + X
S = I + X
Because net exports (X) is the net foreign investment (NFI), we can write that:
S = I + NFI
Savings = Domestic investment + net foreign investment
The equation shows that national saving must equal the sum of domestic investment and net foreign investment. In other words, when the US citizen sends a portion of their income into savings, they can be used to finance the savings in the country, and for the acquisition of capital abroad.
In a closed economy, net foreign investments are missing (NFI = 0), so the savings are equal to investment (S = I). In an open economy, there are two ways to use the savings: for domestic investment and net foreign investment.
As in previous cases, the changes in the financial system are equally reflected at the left and on the right side of the identity. Suppose that the Smith family has decided to postpone part of their income "for a rainy day." This solution increases national savings, that is, the left side of the identity. If the Smiths put their money in a mutual fund, they can be partly used for the purchase of shares of General Motors, which is building a new plant in Ohio, and partly - for the purchase of shares of Toyota, is investing in the expansion of production in Osaka. Acquisition of a mutual fund are reflected in the change in the right part of the identity. From the point of view of the American accounting, the expenditure of General Motors to build a new factory belong to domestic investment. The acquisition of shares of Toyota by American citizens is the net foreign investments. Thus, all the savings of the US economy have become a part of domestic investment, or part of the net foreign investment.
Works Cited
Fontinelle, Amy. "Marginal Propensity To Consume (MPC) Definition | Investopedia". Investopedia. N.p., 2005. Web. 19 Feb. 2016.
Investopedia,. "Marginal Propensity To Save Definition | Investopedia". N.p., 2014. Web. 19 Feb. 2016.
Investopedia,. "Say's Law Of Markets Definition | Investopedia". N.p., 2010. Web. 19 Feb. 2016.
Investopedia,. "The Multiplier Effect - CFA Level 1 | Investopedia". N.p., 2008. Web. 19 Feb. 2016.
Kazmer, Daniel R, and Michele Konrad. Economic Lessons From The Transition. Armonk, N.Y.: M.E. Sharpe, 2004. Print.
Staff, Investopedia. "Net Investment Definition | Investopedia". Investopedia. N.p., 2006. Web. 19 Feb. 2016.
Study.com,. "Macroeconomic Equilibrium: Definition & Overview | Study.Com". N.p., 2016. Web. 19 Feb. 2016.
