The government raises taxes by $200 billion.

If the
marginal propensity to consume is 0.7, what happens to
the following? Do they rise or fall? By what amounts?
a. Public saving.
b. Private saving.
c. National saving.
d. Investment.

a) Increase in taxes will lead to the increase in public saving by the same amount – 200
billion dollars.

b) The increase in taxes will affect disposable income by the same amount – 200 billion
dollars. With the prosperity to consume 0.7 we can calculate following: ∆Private
saving=200 billion-(0.7-200 billion) = 200 billion-70 billion=130 billion. The private
savings fall for 130 billion dollars.

c) National saving is sum of both private and public savings, so the national savings will
increase for 70 billion dollars.

d) National income identity is described as following: Y=C(Y-T) +I(r)+G. When we

substitute the consumption function and the investment function into national income
identity we get following: Y-C(Y-T)-G=I(r). From this formula we can see that
national savings are equal to the investments. Since national savings increased for 70
billion than investments also increased for the same amount.

National savings are the sum of private sector savings and public sector
savings. It represents the total loanable funds provided by the domestic
economy. This term is also synonymous with gross national savings or
domestic savings.

National saving is an indicator of the health of a country’s investment. A high

level of savings means more sources of loanable funds in the country,
indicating the deepening of the advanced financial markets.

How to calculate national savings

National savings come from two sources the public sector and the private
sector. The private sector consists of household savings and business
savings.
National savings = Private savings + Public savings

Public savings come from the government sector. It is positive when tax

revenue exceeds government spending. Or, when the government runs a
fiscal surplus. And when tax revenues are lower than expenditures, the public
sector experiences dissaving.

Private savings formula

Private savings are the amount of income left after paying taxes and
consumption. The formula for private savings is:

Sp = I + (G – T) + (X – M) …. (equation 1)

In some textbooks, private savings are also written with the equation:

Sp = Y – T – C … (equation 2)

Where:

 Y = Aggregate income, represented by GDP

 I = Private investment
 G = Government expenditure
 T = Tax revenue
 X = Export
 M = Import

Equation 2 shows private savings are the remaining aggregate income after
deducting taxes and consumption. Y-T is national disposable income, i.e., the
aggregate income left after deducting tax payment.

Why I use two equations? Are both are same? And, let’s prove it.

In the income approach, the GDP formula is the same as Y = C + I + G + (X-

M). If you substitute Y into equation 2, you will get:

Sp = Y – T – C = C + I + G + (X-M) – T – C = I + (G-T) + (X-M)

Public savings formula 
Public savings are the amount of tax revenue left after the government
finances all its expenditures. Mathematically, we can write it as follows:

Sg = T – G

If the government runs a fiscal surplus, it means the government is saving. At

that time, tax revenue (T) is higher than expenditure (G).

Conversely, when running a fiscal deficit, there is dissaving in the public

sector. Tax revenue is lower than government spending. Deficit reduces the
total supply of loanable funds.

National saving formula

As a definition, national saving is the sum of private savings and public
savings.

Sn = Sp + Sg = I + (G-T) + (X-M) + T – G = I + (X-M)

From the equation above, you can see, if a country adopts a closed
economy (there is no international trade), the value (X-M) is equal to zero. As
a result, national savings equal investment.

Furthermore, national savings are useful for:

 Financing domestic investment

 Lend foreigners (net exports)

If the government runs a fiscal deficit (public dissaving), one of the conditions
below must occur:

 Private savings must increase

 Domestic investment fall
 Net exports fall

How to calculate the national savings rate

National saving rate is the proportion of domestic savings to aggregate
income. Because GDP represents aggregate income, you can calculate it by
dividing national savings by GDP.

National saving rate = National savings / GDP

This indicator is important to see the domestic financial capacity to grow the
economy. As discussed earlier, national savings are a source of funding for
domestic investment.

If the saving rate is low, domestic investment relies on foreign capital inflows
to grow the economy. Conversely, higher saving rates help finance investment
and increase the productive capacity of the economy.

Why must savings equal investment

National saving is one of the factors driving economic growth in the long run. It
represents a domestic supply for loanable funds for investment to increase the
production capacity of an economy in the long run.

In a macroeconomic, saving equals investment in a closed economy. Savings

represent the supply side of domestic loanable funds. Meanwhile, the
investment represents the demand side. Supply-demand for loanable funds
meets in the financial markets.

To understand, I will take a simple example. Say you want to save Rp100 and
invest it in corporate bonds. At the same time, a company intends to issue
corporate bonds to finance investment in capital goods.

Because you are interested in the yield, you buy all the company’s bonds. As
a result, money flows from you to the company. Your savings will be the same
as company investment.

But, remember, it only applies to the economy in the aggregate. It does not
always apply to every household or company.

Also, savings are not the same as investments if the economy is open.
Savings might flow out to the international financial market rather than the
domestic market.
How does government spending affect
national savings?
If the government runs a fiscal deficit, public savings are negative. National
savings decrease, thereby reducing the supply of loanable funds in the
economy.

Because interest rates represent prices for borrowing money, a decrease in

the supply of funds will drive up interest rates in the economy.

Higher interest rates make borrowing costs more expensive. That affects the
willingness of the private sector to borrow. An increase in interest rates
causes fewer families to buy new homes and fewer companies purchase new
capital equipment.

As a result, the fiscal deficit causes a decrease in business investment

and household consumption. Economists call this phenomenon the “crowding
out effect.” It can reduce the rate of economic growth if household
consumption and business investment are more significant than government
spending.

How national savings affect the trade balance

Before discussing it again, let’s take the national savings formula above:

Sn = I + (X-M)

If national saving exceeds domestic investment (Sn> I), there is an excess

supply of loanable funds. Domestic money will flow abroad, for example, by
investing in other countries’ sovereign bonds. Net exports will increase.

Conversely, when national saving is lower than domestic investment (Sn <I),
net exports will decrease. The domestic economy must borrow from abroad to
finance investment (through capital inflow).

When a country experiences a trade deficit (M> X), it can occur because

domestic savings are inadequate to finance domestic investment (Sn <I). Or, it
happened because of the government’s fiscal deficit.

For example, if the national saving is IDR1,000 and domestic investment is

IDR2,000, then net exports will be equal to IDR1,000 (trade deficit).
Say, private sector savings are IDR3,000 and domestic investment is IDR600.
Hence, the government budget deficit will equals:

 Sp + Sg = I + (X-M)
 IDR3,000 + Sg = IDR2,000 – IDR1,000
 Sg = – IDR2,000