Question

If the imaginary economy has a reform, and then changes to an open economy, what is the new relationship between domestic investment and national saving?

Answer 1

In a closed economy Equilibrium occurs when Y = AE

where Y = National income, AE = Aggregate expenditure and in a closed economy AE = C + I + G, C = consumption, I = domestic investment and G = Government expenditure.

Thus, Y = AE => Y = C + I + G => I = Y - C - G ------------------------(1)

National saving = Private saving + Public saving

As, Private saving = Y - C - T and Public saving = T - G, where T = Taxes

Thus National Saving(NS) = Y - C - T + T - G = Y - C - G

From (1) we have NS = Y - C - G = I

=> National saving = Domestic Economy.

After Reforms this economy changes from Closed to open economy.

Now,

In an open economy Equilibrium occurs when Y = AE

where Y = National income, AE = Aggregate expenditure and in a open economy AE = C + I + G + X - M, C = consumption, I = domestic investment, X = Exports, M = Imports and G = Government expenditure.

Thus, Y = AE => Y = C + I + G + X - M => I = Y - C - G - X + M------------------------(2)

National saving = Private saving + Public saving

As, Private saving = Y - C - T and Public saving = T - G, where T = Taxes

Thus National Saving(NS) = Y - C - T + T - G = Y - C - G

Putting this in (2) we have I = NS - X + M

=> NS = I + X - M and as Nat exports(NX) = X - M

=> NS = I + NX

Thus we have National saving = Domestic Investment + Net Exports.