Question

What does economic theory suggest is the long run relationship between changes in a country’s level of savings and its level of investment? Explain how your answer depends upon whether or not the economy is open or closed.

Answer 1

There exists a long run relationship between changes in a country's level of savings and level of investment in the economy. If the economy is closed, then increase in the level of savings in the economy, reduces the rate of interest in the economy and as the rate of intrrest decreases in the economy, the level of investment increases in the long run. Thus, when the economy is closed, then increase in the country's level of savings increases the level of investment in the economy.

On the other hand, in case of an open economy, as the level of savings increases more than the level of investment, then net capital outflow from the economy occurs to invest in other countries with a higher rate of interest than rate of interest in the home country in order to earn higher profits. Thus, in an open economy, capital outflow occurs in the economy.