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Private savings are the lifeblood of a nation’s economic potential. They represent the money households and businesses set aside, rather than spending it all on consumption. High levels of private savings contribute to a country’s overall savings and investment picture, ultimately driving long-term economic growth. This guide dives deep into the concept of private savings, explaining their role in national savings and how they fuel a nation’s prosperity.
Understanding private savings
Private savings are the money households and businesses set aside, rather than spending it all on consumption. This includes the money you save in your bank account, the portion of your paycheck directed towards retirement funds, and the profits businesses retain instead of paying out as dividends. In simpler terms, private savings represent the leftover income after taxes and everyday expenses are covered.
Why are private savings important? They act as the domestic supply of loanable funds within a country. These saved funds become available for investment in businesses, infrastructure projects, and other productive activities. Essentially, high levels of private savings translate to more money for investment, which can fuel economic growth by:
- Boosting capital accumulation: More savings allow businesses to invest in new machinery, buildings, and technology, ultimately leading to increased productivity.
- Lowering borrowing costs: When there’s a surplus of loanable funds, interest rates tend to be lower. This makes borrowing more affordable for businesses and individuals, further stimulating investment spending.
Private savings are a crucial component of a nation’s overall savings picture. They, along with public savings (government savings), contribute to national savings. National savings represent the total amount of money saved within a country and play a vital role in driving long-term economic prosperity.
Components of private savings
Private savings come from two main sources: households and businesses. Understanding these components is key to grasping the overall picture of private savings.
Household savings refers to the portion of disposable income that individuals and families choose to save instead of spending on everyday needs. Factors influencing household savings levels include:
- Income: Generally, people with higher incomes have more disposable income available for savings.
- Wealth: Individuals with greater wealth (assets minus liabilities) tend to have a larger savings buffer and may be more comfortable saving a higher portion of their income.
- Debt: High levels of debt, such as student loans or credit card debt, can limit the amount of money available for savings. Interest payments on existing debt may take priority over saving for the future.
Business savings also contribute to private savings. This includes the profits they retain and reinvest back into the company’s operations, rather than paying them out as dividends to shareholders. These retained earnings are often referred to as undistributed corporate profits. Businesses accumulate savings for various reasons, such as:
- Funding future growth and expansion projects, like opening new stores or developing new products.
- Building a financial cushion to weather economic downturns or unexpected expenses.
- Investing in research and development to improve products and gain a competitive edge
Calculating private savings
The economist defines private savings in the following mathematical formula
- Private savings = household savings + business sector savings
In aggregate, the formula for savings from the private sector is:
- S = Y – T – C
Where
- S: Private savings (the amount of money saved by households and businesses)
- Y: Aggregate income (total income of a country, often represented by Gross Domestic Product or GDP)
- T: Tax revenue (the money collected by the government from taxes)
- C: Consumption spending (the money spent by households and businesses on goods and services)
As explained by economists, money is used for two objectives, namely savings and consumption. In other words, we can explain savings as the remaining money after being reduced by consumption. The second formula above explains it, namely private savings, which is the income earned by the private sector after being reduced by taxes paid and the consumption of goods and services.
Private savings and national savings
Private savings are another component of national savings. In other words, national savings are equivalent to private savings plus public savings (government savings). You can visualize this with the formula: Sn = Sp + Sg (where Sn = national savings, Sp = private savings, and Sg = public savings).
By definition, private savings are the sum of household sector savings and business sector savings. Household sector savings refer to the portion of income that individuals or households choose to save rather than spend on consumption. They include funds held in various forms, such as bank accounts, retirement funds, or other investment vehicles.
Business sector savings is the sum of undistributed corporate profit and capital consumption allowances. We call undistributed corporate profit retained earnings in accounting. Meanwhile, capital consumption allowances are the amount of money that businesses must reinvest in to maintain existing productivity, which is equivalent to the depreciation of capital assets.
Meanwhile, government savings, often referred to as public savings, are the difference between government revenue and expenditures over a specific period. Government savings are determined by the fiscal policies and budget decisions the government makes. They include taxes collected and government spending on various programs and services.
Government saving reflects the government’s fiscal stance. A budget surplus indicates that the government is saving, while a deficit implies that it is borrowing or using reserves.
A budget surplus can contribute to national savings and reduce the need for government borrowing. A deficit, on the other hand, may lead to increased government debt.
The importance of national savings
High levels of national savings benefit a country’s economic growth in several ways. These savings provide a domestic pool of funds for investment in businesses, infrastructure, and other productive activities. This can lead to:
- Increased productivity and economic output
- Creation of new jobs
- Lower borrowing costs for businesses and individuals
By understanding the relationship between private savings and national savings, we can gain a clearer picture of a country’s financial health and its potential for long-term economic prosperity.
The link between savings and investment
Let’s take back the formula S = Y – T – C. Then, let’s describe the aggregate income (Y) by recalling the GDP formula using the expenditure approach.
In calculating the GDP using the expenditure approach, economists formulate aggregate income (Y) as household consumption (C) plus business investment (I), government income (G), and net export (export (X) minus imports (M)). Or mathematically, we write:
- Y = C + I + G + (X-M)
Then, let’s replace Y in the private savings formula with the formula above. So, we get:
- S = Y – T – C
- S = C + I + G + (X-M) – T – C
- S = I + (G – T) + (X – M)
- S-I = (G – T) + (X – M)
Government expenditure minus tax revenue (G-T) represents the fiscal balance or public savings. Exports minus imports (X-M) refers to the trade balance or net exports. Net private savings (S-I) is the remaining savings after deducting investment.
The last formula above explains how a country finances its domestic investment. When the economy experiences a fiscal deficit (G <T) and a trade deficit (X <M) – or “twin deficit”-, net private savings (S-I) are negative. It means domestic private savings are insufficient for domestic private investment (S <I). Hence, the country must borrow from abroad. Foreign capital should be inflow, and the capital account should be a deficit.
Factors affecting private savings
Several factors influence the level of private savings within a country. Here are some key drivers:
- Income and wealth: Individuals with higher income and wealth tend to save a larger portion of their earnings. This is because they have a greater buffer after covering basic needs. Conversely, those with lower incomes may struggle to save after meeting essential expenses.
- Debt: High levels of debt, such as student loans or credit card balances, can limit savings potential. Interest payments on existing debt take priority for many, leaving less available for saving.
- Interest rates and inflation: Interest rates play a significant role. Higher interest rates incentivize saving, as they offer a better return on saved funds. Conversely, low interest rates may make saving less attractive. Inflation also impacts savings. If inflation is high, the purchasing power of saved money erodes over time, potentially discouraging saving.
- Public savings (government policy): Government policies and spending habits can influence private savings. For example, a budget surplus (government saving) can lead to higher national savings, potentially lowering interest rates and encouraging private savings. Conversely, a budget deficit might lead to higher interest rates to attract borrowing, potentially disincentivizing private savings.
- External factors (terms of trade and foreign saving): A country’s trade performance and access to foreign savings can also play a role. Favorable terms of trade (exporting more than importing) can increase national income, potentially boosting private savings. Additionally, if a country can easily access foreign savings, it may rely less on domestic savings, potentially impacting private saving levels.
- Demographic factors: An aging population can affect savings. As people approach retirement, they may save more to prepare for their later years.
