Question

Discuss these statements:

1. If national savings decline, what will happen to domestic investment and net foreign investment?

2. If a country saves more than it invests domestically, what must be true of its net foreign investment?

Answer 1

We starts with the income identity Y= C+I+G and then BOP

Domestic saving (S) being equal to S=Y-C-G (income - consumption)

In a closed economy S=I always but not the case with an open economy. Where Current account CA = EX - IM.

S = I + CA or S-I = CA

Hence there is an essential connection of saving, and investment with CA and Capital account via a balance of payment (BOP). Here private firms can borrow money from the foreign market to finance domestic investment. At the national level deficit in CA must be funded by capital account surplus means foreign capital inflow, which alters the financial liabilities and assets. Net foreign investment equals to capital outflow - capital inflow also called as net capital outflow.

Any transactor the excess of investment over saving coincides with the change in his net liabilities

1. Here S being shortfall then domestic investment will be financed by foreign borrowing. So it will reduce net foreign investment. While it works through the CA deficit, which will be seen as the gap between S and I. Hecen CA deficit will be financed by capital inflows; hence net capital outflow will be lower. Here the domestic investment is independent of S, so I mean that saving is not lesser as compare to I.

2. Here saving exceeds domestic investment so it will cause a positive CA surplus so it will increase net foreign investment as extra saving will be gone to foreign lending. Hence CA surplus equalises BOP when there is a deficit in the capital account so capital will flow out. Accordingly, the net capital flow will increase.