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T H E S AV I N G – I N V E S T M E N T A P P R O A C H T O E Q U I L I B R I U M 1

The Saving–Investment Approach to

Equilibrium in an Open Economy
with Government
In the simple closed-economy macro model in Chapter 21 of the textbook, we saw an
alternative way for stating the equilibrium condition for GDP: At the equilibrium level
of GDP, desired saving equals desired investment. In Chapter 22 we then added foreign
trade and government to the model. Here we examine the saving–investment approach
to equilibrium in this expanded model. We see that the precise form of the equilibrium
condition is modified, but the central underlying principle is the same. Instead of hav-
ing desired saving equal to desired investment, equilibrium in this open-economy
macro model requires that desired national saving be equal to desired national asset
formation.We begin our analysis by defining these new terms.

National Saving
In the model in Chapter 21, all saving was done by the private sector because there was
no government in the model. In our expanded model with government, however, we
must make the distinction between private saving and public saving. Private saving (S) private saving Saving on
is the part of disposable income that is not used for current consumption: S  YD  C. the part of households—
Public saving is the part of government net tax revenues that is not spent on the pur- the part of disposable
chases of goods and services; it is the government’s budget surplus, T – G. National income that is not spent on
saving is the sum of private and public saving, S  (T  G). current consumption.
The national saving function is illustrated in Figure 1, and is based on the specific
public saving Saving on
model we developed in Chapter 22 in the textbook. The slope of this function is the sum
the part of governments,
of the slopes of its two parts, private saving and public saving. In the model represented in
equal to the government
the figure, the net tax rate, t, is 0.1. Thus, when national income rises by $1, public saving
budget surplus.
(T  G) rises by 10 cents. (Recall that G is assumed to be autonomous and so does not
change when national income changes.) The remaining 90 cents is added to disposable national saving The sum
income. From this 90-cent increase in disposable income, households increase their con- of public saving (T  G)
sumption by 72 cents (MPC  0.8) and their saving by 18 cents (MPS  0.2). The increase and private saving (S).
in national saving per marginal dollar of national income is therefore t  MPS(1  t), or
0.1  (0.2) (0.9)  0.28. This is the slope of the national saving function.

National Asset Formation

In the model in Chapter 21, all of national output was either consumption or invest-
ment goods. In addition, all income that was received by households was either con-
sumed or saved. So the saving of households was the counterpart of the economy’s
investment. In the closed economy of Chapter 21—and indeed in any closed econ-
omy—the only way to accumulate assets for future use is to devote some part of
national output to investment, and that investment must be financed by saving. In an
open economy, however, it is possible to accumulate assets in a different form—as net
claims on foreigners, which could be foreign bonds, foreign bank deposits, or owner-
ship of foreign factories or land. Net exports are central to determining the rate at
which a country acquires such claims on foreigners.

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.
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2 T H E S AV I N G – I N V E S T M E N T A P P R O A C H T O E Q U I L I B R I U M

FIGURE 1 National Saving and National Asset Formation

The economy is in equilibrium when desired national saving,
(S ⴙ T ⴚ G), equals desired national asset formation, (I ⴙ

Desired National Saving,

Desired Asset Formation
X ⴚ IM). The figure graphs the function from the second and
third columns of the accompanying table; equilibrium national S + (T – G)
income is equal to $600 billion. When national income is less
than $600 billion, desired national asset formation exceeds 147
desired national saving and desired aggregate expenditure I + (X – IM)
exceeds national income. Firms will respond to the imbalance 0
by producing more, moving the economy toward equilibrium. 300 Y0 900 1200
When national income is above $600 billion, desired national –81
asset formation is less than desired national saving, and desired 600
aggregate expenditure is less than national income. Firms will
reduce output to avoid accumulating excess inventories, and
Actual National Income
the economy will move toward equilibrium.

Actual Desired Desired Saving Minus

National Income National Saving National Asset Formation Asset Formation
(Y) (S  T  G) (I  X  IM) (S  T  G)  (I  X  IM)
0 81 147 228
300 3 117 114
600 87 87 0
900 171 57 114
1200 255 27 228
This figure and associated table are based on a macro model described by the following equations:
C  30  0.8YD G  51
YD  Y  0.1Y X  72
I  75 IM  0.1Y

Investment and net exports thus have a great deal in common: They are the two
ways that current output can be used to accumulate assets. Investment, by definition, is
production that will yield services in the future rather than in the present. Clearly, an
economy that invests is adding to its assets.
To demonstrate that net exports also lead to asset accumulation, we must go
through a number of steps. First, we note that net exports are the difference between
what an economy produces and what it uses for consumption, investment, and govern-
ment. An economy whose net exports are positive is producing more than it is using,
with the difference sold abroad. Similarly, an economy that has negative net exports is
using more than it is producing, with the difference purchased from abroad.
What happens when a country has positive or negative net exports? Here, the anal-
ogy to an individual is instructive. Suppose you spend more than you earn and that you
borrow money to cover the difference. You consequently go into debt. Now suppose
that you earn more than you spend. As a result, you acquire assets (or reduce your
debts). Spending more than you earn reduces your net asset position, and earning more
than you spend increases your net asset position.
This simple idea can be extended to the national level because a nation’s balances
between expenditure and income are simply the total of what individual citizens do. If
Canada’s firms, households, and governments sell more goods and services to other
countries than they buy from them (X exceeds IM), Canadians must accumulate foreign

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.
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T H E S AV I N G – I N V E S T M E N T A P P R O A C H T O E Q U I L I B R I U M 3

assets. These assets could be in the form of foreign currency, balances in foreign banks,
foreign stocks and bonds, or even foreign lands and factories.
Conversely, if Canada’s firms, households, and governments spend more on foreign
products than they earn by selling Canadian products to foreigners (IM exceeds X), Cana-
dians must incur foreign liabilities (or run down foreign assets.) To finance the excess of
imports over exports, funds must come from somewhere. Since they are not earned by
selling current output, they must be raised by selling assets to foreigners. As a result, a new
liability is generated domestically, in the form of domestic assets held by foreigners.
Again, these could be bank balances, stocks and bonds, or titles to factories and farms.

Net exports result in the accumulation of foreign assets for the exporting country.
Hence, net exports are like investment in the sense that they generate future
income for the exporting country.

To summarize, in a closed economy, national asset formation is just equal to national asset formation The
investment. In an open economy, however, we must add net assets accumulated abroad sum of investment and net
(equal to positive net exports) or subtract net domestic assets accumulated by foreign- exports. The extent to
ers (equal to negative net exports) in order to calculate the extent to which the domes- which the domestic
tic economy is accumulating assets worldwide. economy is accumulating
Figure 1 shows the national asset formation function, I  (X  IM). Recall that I (domestic and foreign)
and X are both autonomous, whereas IM rises as national income rises. The result is a assets.
negative relationship between national income and national asset formation.

Equilibrium
Figure 1 shows both the national saving function and the national asset formation
function. With the two relationships together, we can determine the equilibrium level
of national income. National income will be at its equilibrium level when the following
condition holds:

S + (T - G) = I ('')''*
('')''* + (X - IM)
Desired Desired
national national
saving asset formation

When desired national saving is equal to desired national asset formation, national
income is at its equilibrium level.1
1 Some readers may have noticed in our analysis that government saving only takes the form of repaying debt,

and is not used to finance public investment in items such as bridges, dams, or highways. This is a simplify-
ing assumption only, for actual governments clearly do invest in such physical assets. Interestingly, however,
our simplification does not alter the equilibrium condition. To see this, divide total government purchases of
goods and services, G, into its two components: GC is government consumption and GI is government invest-
ment. The government’s saving is now equal to T  GC and so the equilibrium condition becomes:

S  (T  GC)  I  GI  (X  IM)

But if we rearrange terms by moving GI to the left-hand side of the equation, and note that G  GC  GI,
we get back to the equilibrium condition shown in the text. The conclusion is as follows. When governments
save by acquiring physical assets, they contribute equally to the saving and investment sides of the equation.
Thus, our simplifying assumption (that governments do not invest in physical assets) does not alter the level
of national income determined by the equilibrium condition.

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.
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4 T H E S AV I N G – I N V E S T M E N T A P P R O A C H T O E Q U I L I B R I U M

To see why equilibrium occurs when desired national saving equals desired
national asset formation, it is crucial to recognize that the gap between the two curves
in Figure 1 is exactly the same as the gap between the associated AE curve and the 45°
line. Indeed, by picking any level of national income and comparing the tables in these
two figures, you will see that the difference between actual national income and desired
aggregate expenditure is always equal to the difference between desired national saving
and desired national asset formation.
Let’s use a little algebra to see why this must be the case. Suppose the difference
between desired national saving, (S  T  G), and desired national asset formation,
(I  X  IM), is equal to some number, which we call W. In symbols, this is

(S  T  G)  (I  X  IM)  W

Now, recall that disposable income is equal to actual income minus taxes, Y  T.
Further, note that all of disposable income must be used up by consumption and saving.
That is,

YTCS

which implies

SYTC

Now, this last equation can be substituted into our first equation above and, after a
little rearranging of terms, we get

Y  [C  G  I  (X  IM)] W

Finally, note that the expression in square brackets is simply desired aggregate expen-
diture, AE, and so the equation can be rewritten to be

Y  AE  W

We have just shown that the difference between desired national saving and desired
national asset formation, which we called W, is exactly the same as the difference
between actual national income and desired aggregate expenditure. It immediately fol-
lows that the equilibrium illustrated in Figure 1 is just another way of looking at the
same equilibrium that we could alternatively illustrate in a diagram with an AE curve
and a 45° line.

Ragan, Economics, 14th Canadian Edition

Copyright © 2014 Pearson Canada Inc.