The saving and investment equation is a core concept in macroeconomics that states that total saving in an economy must equal total investment. This is a key accounting identity based on how gross domestic product is measured. Understanding this concept is crucial for analyzing financial systems, loanable funds markets, government policy impacts, and connections between saving and investment behavior.
National saving equals private plus public saving
According to the income expenditure approach to measuring GDP, total national saving is defined as national income less consumption and government expenditures. National saving thus consists of saving by the private sector (households and firms) as well as by the public sector (government). The private saving rate depends on household preferences whereas public saving depends on the government’s budget balance.
In a closed economy, saving funds investment
The sources of saving in an economy, from both private and public sectors, comprise the supply of loanable funds available for investment spending. For a closed economy without foreign trade, total investment demand must be funded from national saving. Hence, the familiar identity that total saving equals total investment.
Crowding out effects of budget deficits on investment
When governments run sustained budget deficits, meaning public saving is negative, the supply of domestically available loanable funds for investment shrinks. Persistent deficits crowd out private investment by reducing the pool of national saving available to fund productive projects. Taxes also influence private saving rates.
The saving and investment equilibrium interest rate
The interaction of saving and investment determines the economy’s equilibrium interest rate in loanable funds markets. Shifts in saving or investment affect this rate and the level of investment and GDP. Therefore, policies influencing saving and investment incentives also impact interest rates, output, and growth over time.
The macroeconomic saving-investment identity shows that total saving from all sectors will always fund total domestic investment spending in a closed economy without trade. Variations in public and private saving behavior, due to policy and other factors, shift the supply of loanable funds and determine interest rates and investment levels over the business cycle.