Saving and Capital Formation
14 Mar 2025
Saving and investment are two sides of the same coin. When a person or a business saves, they are increasing the pool of funds that are available for investment. Borrowers who are looking to make big purchases, such as buying a house or building a factory, can use these funds to finance their projects.
At the individual or household level, saving is income less spending. When people spend less on goods and services, they save more. One interesting question is why people save. People save to meet future needs, such as retirement or education expenses. They also save to protect themselves against unexpected events, or to leave an inheritance for their children. One key determinant of the saving rate of households is the interest rate, which dictates the amount of return that savers can expect to earn on their savings. In general, higher interest rates translate into higher saving rates.
Let's look at GDP and how it relates to saving and investmet at the national level. GDP has four components:
GDP = C + I + G + NX
where
We assume that the economy is closed, so NX = 0. Also, all government expenditures are categorized as current spending, which is a simplification, since governments do make investments in infrastructure and other projects. Since saving is used to finance investment projects, we can rewrite the equation as:
GDP = C + (S) + G + (0)
GDP = C + S + G
S = GDP - C - G
where
If we think of GDP as national income, then this equation becomes simpler and more intuitive. Saving is national income less consumption and government spending. These savings are, in turn, channeled into domestic investment projects. Economists call this process capital formation.
National saving can be broken down into two components: private saving and public saving. Let's go back to the equation for S, and introduce taxes:
S = GDP - C - G + (T - T)
S = GDP - C - T + T - G
S = (GDP - C - T) + (T - G)
S = Sprivate + Spublic
where
Sprivate can be further broken down into household saving and corporate saving. A household saves when it spends less than its after-tax income. A corporation saves when it retains after-tax earnings rather than paying them out as dividends. Spublic is the difference between the government's tax revenue and its spending. When Spublic is positive, we say that the government is running a budget surplus. When Spublic is negative, we say that the government is running a budget deficit. Whether a government runs a surplus or a deficit depends on its fiscal policy, and fiscal policy has important implications for the economy, as we will see.
When do firms decide whether to invest in new projects? The answer is simple: if the expected return on the project is greater than the cost of financing it. Return depends on many factors, but most importantly is the cash flow that the project is expected to generate. The cost of financing depends most crucially on the interest rate. Generally speaking, firms are more inclined to invest in new projects when interest rates are low, because they can borrow money cheaply.
Thus, interest rates play a crucial role in the capital formation process. Economists like to think of interest rates as the price of money. Like all prices, interest rates are determined by supply and demand. Many factors can affect both the supply and demand for money: