PART 2 THE ECONOMY IN THE LONG RUN

…
4 Saving and Investment in Closed and Open Economies

4.0 Notations, etc.

Y = output or income; C = consumption; S = private saving, T = personal taxes; A = aggregate demand;

I = investment; G = Government spending; G – T = budget deficit (+) or surplus (-); Sg T – G =
government saving (+) or dissaving (-); Sn = S + Sg = national saving; r = real interest rate. These
variables are assumed to be in real terms.

If = net foreign investment = our investments abroad – foreigners’ investments here ; NX = X – M = net
exports of goods and services; CA = NX + net unilateral transfers = current account surplus (+) or deficit
(-); FA = net financial inflow = financial inflow – financial outflow = financial account surplus (+) or
deficit (-); KA = capital account; 0 = CA + FA + KA = BOP = balance of payments.

Assume that net unilateral transfers = 0 so that CA = NX. Assume also that KA = 0 so that BOP = CA +
FA = 0 and thus CA = - FA. Note that CA = If , since – FA = If .

CA surplus(CA  0 )  FA deficit( FA  0 )  I f  0
So, and
CA deficit(CA  0 )  FA surplus( FA  0 )  I f  0
.

4.1 C (and Saving) and Investment

4.1.1 S = S(r, …), saving function

1) The C function (and therefore the S function) can derived …

2)

4.1.2 I = I(r, …), investment function

1) The I function can be derived …

2)

Econ 101/F.B.Natividad-Carlos 22 June 2012 1

4.2 Interest Rate Determination in a Closed Economy

4.2.1 Given

Sn  I
S  I G T Sn  S  T  G  S  Sg
S  S ( r ,...) S  S( r ,...)
I  I ( r ,...) I  I ( r ,...)
G  G0 G  G0
T  T0 or , equivalently, T  T0

where ….

Note that the closed-economy equilibrium condition S  I  G  T or, equivalently, Sn  I is derived

from the equilibrium condition Y  A where Y  C  S  T and A  C  I  G .

4.2.2 r deremination (i.e., determination of the equilibrium real interest rate)

1) Graph: S(r) curve and I(r) + G-T curve

2) Graph: S(r) + T – G or Sn curve and I(r)

4.2.3 Using the diagrams. The effects on … of each of the following:

1) increase in the desire to save

2 increased business optimism

3) increase in govt spendingfinanced by borrowing from the public

4) increase in govt spending financed by raising taxes

Econ 101/F.B.Natividad-Carlos 22 June 2012 2

4.2.5 The loanable funds model

1) The S curve is the supply of loanable funds (LFS) curve.

- assumption: no hoarding. Whatever is saved is loaned out.

2) The I + G-T curve is the demand for loanable funds (LFD) curve.

- assumption: all I is financed by borrowing from the public.

3) Graph: LFD curve and LFS curve

4) Using the LFD-LFS diagram, along with the S – I+G-T diagram

5) Later, we shall link the loanable funds framework (LFS-LFD model, a model for r determination in
the LR) and the liquidity preference framework (Ms/P- L model, a model for r determination in the
short run).

4.3 Small Open Economy under Perfect (financial) Capital Mobility and Substitutability

small …, , open …

4.3.1 PKM …, PKS …

1) r = rf

2)

4.3.2 Diagram: Sn curve and I curve, with r = rf.

1) equilibrium

2)

4.3.3 Using the Sn – I diagram. Effects on … of ….

Next: If r = rf and rf is taken as given, what do Sn-I and NX determine?

Econ 101/F.B.Natividad-Carlos 22 June 2012 3