When people talk about setting funds away in order to earn a return and fund greater levels of future consumption, they generally refer to this activity as "investing"- as in "I just invested $1,000 in the stock market," for example. In economic terms, however, what people are actually doing in this case is called saving, but there is a relationship between household saving and the level of investment in an economy Before we analyze this relationship, however, it's important to make sure that we understand specifically what both of these terms mean.
Households in an Economy Consume and Save
Households have two options for what they can do with their after-tax disposable income- they can use it to fund current consumption or they can save it in order to fund future consumption. This implies that the amount of consumption plus the amount of saving in an economy must equal the total amount of disposable income in an economy. Using standard macroeconomic variables, this means that Y - T must equal C + S.
Put another way, S must equal Y - T - C, or savings comprises all income that doesn't go to taxes or consumption.
Firms in an Economy Borrow in Order to Invest
Investment, in economic terms, refers to business activities that involve the purchase of new productive capital (i.e. machines) and strategic inventory accumulation. (The accumulation of inventory counts as investment in the definition of aggregate expenditure.) Technically, investment also refers to the purchase of new residential construction by households.
In order to fund investment, firms use funds that are borrowed from the households that save.
In fact, money saved by households is referred to as financial capital, and markets that bring saving households and investing firms together are called capital markets. Firms can either borrow explicitly by taking out loans or issuing bonds or they can borrow implicitly by using retained earnings to purchase capital rather than distributing earnings to shareholders as dividends. In addition, households generally borrow in order to fund residential investment by taking out mortgages to pay for their homes.
Investment as a Component of Aggregate Expenditure
The aggregate expenditure definition of gross domestic product tells us that aggregate expenditure or income is the sum of consumption, investment, government spending, and net exports. Rearranging this identity and using standard macroeconomic variables tells us that I must equal Y - C - G - NX.
The Parity Between Saving and Investment
Our previous discussion shows that we have two ways to represent aggregate expenditure or income (Y), one that involves saving and one that involves investment. Namely:
- Y = C + I + G + NX
- Y = C + S + T
Therefore, it must be the case that C + I + G + NX is equal to C + S + T. Subtracting consumption from both sides and rearranging the terms tells us that S must equal I + (G - T) + NX.
From this equation, we can tell that saving equals investment when the government runs a balanced budget (ie. G is equal to T) and when net exports are equal to zero. That said, it's helpful to think about the factors that cause the amount of saving in an economy to deviate from the amount of investment.
First, when the government runs a deficit (i.e. when G is less than T), it borrows in order to fund that deficit by issuing Treasury bonds.
These bonds give savers an alternate way to earn a return on their savings that does not result in domestic investment, and some saving gets diverted to these Treasury bonds. In cases where the government is borrowing, G - T will be negative and, not surprisingly, private investment will be less than the amount of saving in the economy.
The more interesting observation is that saving and investment fail to reach parity with net exports are present. To understand this, it's important to remember that saving refers to saving by domestic households only, and investment refers to investment in domestic firms only. In an economy where international trade is present, domestic households have the option to either fund investment of domestic firms or of foreign firms.
Similarly, domestic firms also have the option of seeking financial capital from foreign savers as well as from domestic savers.
Domestic saving fails to reach domestic investment when net capital outflows are present- i.e. when the amount by which domestic savers fund foreign companies differs from the amount by which foreign savers fund domestic companies. Interestingly enough, there is parity between net capital outflows and net exports, so net exports can in fact represent the amount by which domestic saving differs from domestic investment.