I learned in a textbook that the formula for I, which represents the investment
ID: 1247547 • Letter: I
Question
I learned in a textbook that the formula for I, which represents the investment in the economy, is:I = Sp + Sb + Sg + (imports minus exports).
Sp represents personal savings. This money does not go into the economy. So why is it counted in this formula?
The presence of Sb here I understand. At least I think I do. Sb stands for the amount of investment done by the business sector.
Sg I understand too. It stands for the investment in the economy done by the government.
Then we come to the "( imports minus exports)" part of the formula. I don't understand this either. Shouldn't it be the reverse - shouldn't we be doing ( exports minus imports)? After all, don't imports drain the economy, whereas exports bring money that can be seen as an investment in the economy.
I'm trying to understand the logic here, that's all.
Thank you
Explanation / Answer
First you have to come to an understanding in your mind that when Economist refer to this formula measuring 'Investments' it is a different definition they use for the term instead of what financially minded people use for the word. Investments to a Macro economist are any investments (Financially or Physically or Educationally) into future capital growth and production. Let me give a couple examples: Mr. Smith could purchase $5Million dollars of IBM stock from a brokerage firm (This is NOT considered investment to an economist because all this has done is transfer wealth from one person to another, no new wealth was generated). General Motors could decide to sell $10Million dollars worth of new stock on the market. (This is considered investment, because GM will now be using the proceeds from the new stocks they are selling to perhaps build a new car factory, or purchase more units of capital to increase production among workers, etc.) So with this concept in mind let's go back to your formula. Firstly, Sp (Personal Savings) does go back into the economy and is investment to economist because personal savings is counted in this model as when I put money into a back. Now some banks will offer interest checking or interest savings accounts, ever wondered why? It is not just a marketing scheme, it is also compensation to you for letting them use your money. When you deposit money into your checking account, it does not sit there until you want it. Banks take your money and INVEST IT. They take all of their customer's money(Except for what they are required to keep in reserves) and give out home loans, car loans, business loans, etc, (This is how banks make their money). So personal savings is investment in the economy because it opens more cash flow for future loans for businesses to purchase more capital, or build another factory, etc. Sb you said you mostly understand, this is not businesses investing their proceeds into stock or anything here. Sb would be, like you could probably guess, when a business takes its money and invests into factors of production. This could be investment into buying new machines, or hiring new employees, or building new factories, or human capital is a big one (Investing in the education of your employees). Sg you said you get, should be straightforward like the government spending money for new railroads, bridges, highways, (this is them investing in our country's infrastructure). Now the last part (Net Imports), this is big, but easy to get if you think about it backwards. In measuring GDP we count exports minus imports because, like you said, exporting makes the country money while importing cost money. But in the Investment function we are measuring things that invest into our economy's future growth and expansion. So in this case an economist would view imports as investment from a foreign country into our own. Imports does not have to be cars we import or other items, it could also be a factory that a foreign country builds here, and so on. Hope this helps clear up the rationale behind this model.