In general, saving equals current income minus spending on current needs; the saving rate is the percentage of income that is saved. Wealth, or net worth, equals the market value of assets (real or financial items of value) minus liabilities (debts). Saving is a flow, being measured in dollars per unit of time; wealth is a stock, measured in dollars at a point in time. As the amount of water in a bathtub changes according to the rate at which water flows in, the stock of wealth increases at the saving rate. Wealth also increases if the value of existing assets rises (capital gains) and decreases if the value of existing assets falls (capital losses).
Individuals and households save for a variety of reasons, including life-cycle objectives, as saving for retirement or a new home; the need to be prepared for an emergency (precautionary saving); and the desire to leave an inheritance (bequest saving). The amount people save is also affected by the real interest rate, which is the "reward" for saving. Evidence suggests that higher real interest rates lead to modest increases in saving. Saving can also be affected by psychological factors, such as the degree of self-control and the desire to consume at the level of one's neighbors (demonstration effects).
The saving of an entire country is national saving S. National saving is defined by S = Y 2 C 2 G, where Y represents total output or income, C equals consumption spending, and G equals government purchases of goods and services. National saving can be broken up into private saving, or Y 2 T 2 C, and public saving, or T 2 G, where T stands for taxes paid to the government less transfer payments and interest paid by the government to the private sector. Private saving can be further broken down into household saving and business saving. In the United States, the bulk of private saving is done by businesses.
Public saving is equivalent to the government budget surplus, T 2 G; if the government runs a budget deficit, then public saving is negative. The U.S. national saving rate is low relative to other industrialized countries, but it is higher and more stable than U.S. household saving.
Investment is the purchase or construction of new capital goods, including housing. Firms will invest in new capital goods if the benefits of doing so outweigh the costs. Two factors that determine the cost of investment are the price of new capital goods and the real interest rate. The higher the real interest rate, the more expensive it is to borrow, and the less likely firms are to invest. The benefit of investment is the value of the marginal product of new capital, which depends on factors such as the productivity of new capital goods, the taxes levied on the revenues they generate, and the relative price of the firm's output.
In the absence of international borrowing or lending, the supply of and demand for national saving must be equal. The supply of national saving depends on the saving decisions of households and businesses and the fiscal policies of the government (which determine public saving). The demand for saving is the amount business firms want to invest in new capital. The real interest rate, which is the "price" of borrowed funds, changes to equate the supply of and demand for national saving. Factors that affect the supply of or demand for saving will change saving, investment, and the equilibrium real interest rate. For example, an increase in the government budget deficit will reduce national saving and investment and raise the equilibrium real interest rate. The tendency of government budget deficits to reduce investment is called crowding out
