Economics

Gross domestic product (GDP) is the market value of final goods and services within a country in the current fiscal period. It can be measured in three ways the product approach, income approach, and expenditure approach. The product approach sums the output of all classes of products within a country. The expenditure approach works on the notion that all products must be bought by somebody therefore, the total goods and services purchased in an economy is equal to the GDP. In general, via the expenditure approach, GDP  C(Y, S)  I (r)  Government Spending (R, S)  X (trade surplus or deficit).

Consumption (C) is directly related to GDP the higher the consumption, the higher is the GDP. The same case can be said of investment (I) government spending (G) and net exports. Income (Y) is directly related to consumption (therefore to GDP) savings (S) is inversely related to GDP. The higher the savings, the lower is the marginal propensity to consume, thus, the lower is the GDP. Interest rate is inversely related to investment. The higher is the interest rate the lower is the level of investment. If actual government savings is higher than projected savings, then the lower is the GDP. Orthodox economic theory holds that consumption, investment, government spending are contributors to economic growth. However, the actual relationship between savings and investment has had not been thoroughly examine prior to the 1930s.

Modern economic theory holds that there is an inverse relationship between savings and investment. Before discussing the relationship between the two concepts, it may be prudent to present formal definitions. Savings is defined as disposable income minus personal consumption (Y  C). In other words, savings is the part of the income that is not consumed by immediately purchasing goods and services. Investment, on the other hand, is the commitment of capital to purchase financial instruments or assets in order to gain returns in the form of money, capital, or expropriated value. On the demand side, an increase in savings potential leads to a fall in consumption and therefore a fall in GDP (measured through the spending multiplier). Now, aggregate demand shifts leftward (lower demand schedule). Firms are induced to decrease investment level because of the fall in AD (aggregate demand). The AS curve also shifts leftward. The new equilibrium point, say, Y1 is lower than the previous equilibrium point, say Y. Suppose that interest rate is included in the analysis. An increase in interest rate induces individuals to increase savings. Individuals place their money in financial institutions, expecting higher returns. A higher interest rate decreases investment levels in the economy. Firms will not increase their investment schedules in the present as interest rates are high. If interest rates falls, then individual consumers will increase their consumption schedules and savings will fall. Firms and investors will borrow capital from financial institutions because the net interest cost is lower in the current period. Note that in general, savings and investment are inversely related.

What is the implication of this finding on current saving behavior Individuals do not save simply there is an expected high return in the future. Saving behavior is essentially based on speculative and rational motives. If there is an expected deflation in the future, then saving is necessary (increased purchasing power). If there is an expected inflation in the future, then saving is irrational (lower purchasing power). Savings is also dependent on income. According to the income hypothesis, as income increases, savings also increases. In short, there is a positive relationship between savings and incomes.

According to economists, savings potential in the United States increased over the last 30 years, after income levels increased 10 annually. Now, if there is an expected monetary expansion, individuals will increase spending in the present (because of higher purchasing power). Firms will increase their investment schedules because of the expected expansion (lower interest rate). If there is an expected contraction, individuals will increase their saving potential firms will decrease their investment schedules.

In the 1930s, there is a misconception that savings alone leads to economic recovery. This statement is both true and false. Savings may be considered an initial source of investment. Savings may also be considered a deterrent to investment. If the economy is at its potential, savings can actually be converted to investment in the form of capital. If the economy is in the recovery stage, savings is a deterrent to growth as far as overall investment is concerned. In the United States, increased government savings during the Clinton administration resulted to increased credit ratings. The increase in credit ratings was a signal that the United States was a good country for investment.

The relationship between savings and investment is clear-cut. However, in some countries, savings is positively correlated with investment (like Japan, Taiwan, and Singapore). Perhaps, there is a way around this dilemma. It may be possible to increase savings level and at the same time, increase investment. The net effect may be a higher or lower GDP. In any case, however, the conceptual relationship between savings and investment is not empirically absolute.