What Is The Determination Of Saving And Investment At Full Employment Level?

We need to go beyond the identities to understand the mechanism by which saving and investment are equalized in the open economy. The equilibration of saving and investment in the short run is just the mirror image of the multiplier mechanism. The capital market is the market where the supply of saving is equilibrated with the demand for investment. Let's begin with the closed economy and then extend the analysis to an open economy.


In an open economy we know that investment must equal private savings plus the government surplus. The government surplus depends upon taxes and spending programs, but it does not depend upon the interest rate. Moreover historical experience indicates that private saving is also relatively independent of interest rates. In our analysis we assume that total domestic saving responds positively but only slightly to higher real interest rates.
An open economy has alternative sources of investment and alternative outlets of savings.

A small open economy must equate its domestic interest rate with the world real interest rate. It is too small to affect the world interest rate and because capital mobility is high, financial capital will move to equilibrate interest rates at home and abroad.