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Savings, Investment Spending, and the Financial System

Explain how overall national savings is related to overall investment and why savings is always equal to investment.

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Savings are a part of income that is not consumed now, that is, the accumulation of finance. Therefore, savings, formed by the difference between income and expenses, are the primary investment source. However, this is only happening if these investments promise a profit. Obviously, investments cannot be more significant than savings because people are not able to invest more money than they have (Von Weizsäcker & Krämer, 2021). Saving and investing are similar processes; both actions involve putting away a certain amount of money for the future, but funding is riskier.

Explain the relationship between these two formulas:

  • Y = C + I + G + EX – IM
  • S = (Y – T – C) + (T – G)

The first formula (Y = C + I + G + EX – IM) means that Gross domestic product equals national consumption, national investment, government spending, and current account. The second formula (S = (Y – T – C) + (T – G)) means the national income (overall national savings), which is equal to the sum savings of the private sector and the government’s savings.

These two formulas are directly related to the balance of savings and investment because the difference between national savings and investment is equal to exports and imports.

Explain how changes in interest rates will affect the amount of money that people save.

The current level of interest rates affects the customer’s wish to take out a loan or, on the contrary, put money on a deposit, that is, use all the available funds now or save for the future. If the rate goes down, deposits lose their attractiveness, giving way to credits. People strive to save less amount of money. It is necessary to understand that “lowering rates makes borrowing money cheaper,” therefore, clients desire to spend or invest in them (Seabury, 2021, para. 4). If the rate increases, taking out a loan becomes not as profitable as saving money. Customers try to save all money they have.

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Explain how changes in interest rates and rates of return on various investment options will affect the amount of money that businesses are willing to invest to increase output.

The change in the interest rate also affects the dynamics of investment. Often, the lower the interest rate is, the greater the volume of investments. As for rates of return, investors try to choose the projects that bring them relatively high returns, which will not make them regret losing the chance to get the interest. The total return is “the sum of two parts: the risk-free rate and the risk premium” (McClure, 2020, para. 5). A “risk premium,” can be obtained if the investor chooses a risky venture where the rate is 5%.

Explain how the government’s tax revenue and government spending create either a budget surplus or budget deficit, and how does that difference affect the market for loanable funds?

The budget deficit occurs when budget revenues (tax and non-tax) do not cover its expenses. According to the principle of balance, the volume of the foreseen costs should correspond to revenues. An ineffective tax policy can cause a budget deficit. The budget surplus occurs when the income exceeds the expenses. The state has to borrow money on the world market of loanable funds to estimate the budget deficit.

Use the market for loanable funds shown in the accompanying diagram to answer the following questions.

  1. Assuming there are no external controls on interest rates, what will be the likely results on quantity of money saved, on interest rates, and on additional business investment, if the government significantly increases its borrowing to fund its growing deficit spending?
    1. If the government increases its borrowing, the demand will also increase. The interest rate will increase. And people start saving money.
  2. At any given interest rate, a significant number of middle-class consumers decide to use their credit cards to fund additional purchases. Assuming there are no external controls on interest rates, what will be the likely results on quantity of money saved, on interest rates, and on additional business investment? Assume no change in government borrowing.
    1. If people use their credit cards, the demand will also increase.
  3. At any given interest rate, many major businesses become pessimistic about the future profitability of investment spending. Assuming there are no external controls on interest rates, what will be the likely results on quantity of money saved, on interest rates, and on additional business investment? Assume no change in government borrowing.
    1. If people do not invest, they start saving money.

References

McClure, B. (2020). What investors should know about interest rates. Investopedia. 

Seabury, C. (2021). How interest rates affect the U.S. markets. Investopedia.

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Von Weizsäcker, C. C., & Krämer, H. M. (2021). Saving and Investment in the Twenty-First Century. Springer.

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StudyCorgi. 2022. "Savings, Investment Spending, and the Financial System." December 14, 2022. https://studycorgi.com/savings-investment-spending-and-the-financial-system/.

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StudyCorgi. (2022) 'Savings, Investment Spending, and the Financial System'. 14 December.

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