Dr.

Tulsi Jayakumar 1
ž Remember, Y= C + I + G + X – M
ž We first, take a simple 2 sector model.

ž We derive that S=I

ž Next, we shall reintroduce the govt and
ROW.

Dr. Tulsi Jayakumar 2

ž First key identity- output produced=output sold.
ž What is output sold? This is nothing but components
of demand-
ž Y=C+I………………………………………….(AD)------ (1)
ž i.e. all output is either consumed or invested
(accumulation of inventories)
ž What is output produced? This is nothing but
components of supply/ part of income earned. Part of
the income will be spent on consumption and part
will be saved.
ž Thus, Y= S + C……………………………(AS)………….(2)
ž where S is the private saving

ž Thus, we say Expenditure = Income

ž OR i.e. AD=AS
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ž From 1 and 2,
ž C+I= Y = C +S……………………………………….(3)

ž Value of output produced = Income received and

income received is either spent on consumption
goods or saved.
ž Subtracting C from each part of the identity (3),
ž I = Y-C= S……………………………………………(4)
ž OR I=S
ž In a simple economy, invt is exactly identical
to saving.

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ž We reintroduce the govt purchases of goods
and svs (G), Taxes by TA and transfers to the
private sector (corporate + household) by Tr.
ž Net exports denoted by NX
ž Now, Y= C + I + G + NX……………………….(5)
ž We define Disposable income as YD= Y +Tr –
TA……………………………………………………..(6)
ž Disposable income is allocated to
consumption and saving
ž YD= C+S……………………………………………….(7)
ž Hence, C +S = YD = Y+ Tr- TA………………(8)

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ž Or, C= YD- S = Y +Tr – TA- S…………………….(8a)
ž Stting for C in (5).
ž Y= Y+ I + Tr-TA –S+ G + NX
ž S-I= (G +Tr-TA) +NX………………………………(9)
ž Look at each of these terms-
ž S-I= excess of private savings over
investment
ž G+ Tr-TA= Budget Deficit (BD)/ Public savings
ž NX= X-M= External deficit
ž From (9), if S=I, then BD= -NX
ž Where –NX=M-X

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ž More specifically,
ž S + [TA- (G+ Tr)] + (M- X)= I
ž All domestic private investment has to be
financed by savings- either in the form of
domestic private savings (S) or govt savings [TA-
(G+ Tr)] or external savings (M- X).
ž (M- X) is nothing but the Current account
deficit.
ž Hence the CAD is a proxy measure of the
external savings.
ž Refers to that part of our investment (and
consumption of goods and services) that is
financed NOT by our gross domestic savings (pvt
+ public) , but by foreigners.

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 2004-05 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12
GROSS 32.8 35.7 38.1 34.3 36.5 36.8 35
CAPITAL
FORMATION
(Investment)
Public 7.4 8.3 8.9 9.4 9.2 8.4 7.9
Sector
Private 23.8 26.4 28.1 24.8 25.4 26.5 24.9
sector
Corporate 10.3 14.5 17.3 11.3 12.1 13.4 10.6
sector
Household 13.4 11.9 10.8 13.5 13.2 13.1 14.3
sector
GROSS 28.7 31.3 32.9 32.3 31.7 31.7 30.6
FIXED
CAPITAL
FORMATION
STOCKS 2.5 3.4 4.0 1.9 2.8 3.1 2.1
VALUABLES 1.3 1.2 1.1 1.3 1.8 2.1 2.7
Gross 32.4 34.6 36.8 32.0 33.7 34.0 30.8
Savings rate

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 2007- 2008- 2009- 2010- 2011 2012-
08 09 10 11 -12 13
GDP 9.3 6.7 8.6 9.3 6.2 5.0
growth
rate (GDP
at FC at
constant
prices)

S-I gap -1.3 -2.3 -2.8 -2.8 -4.2

Gross 2.5 6.0 6.5 4.8 5.7 5.1
Fiscal
Deficit
CAB/GDP -1.3 -2.3 -2.8 -2.8 -4.2 -4.6

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ž Look at 2011-12 data
ž Gross Savings (pvt + Public savings)= 30.8%

ž External sector savings= 4.2

ž Hence total savings= 35
ž Gross capital formation=I= 35
ž Savings financed an invt of 35. However, with
lower domestic savings, we had to rely on
external savings, a measure of which is the
CAD to the extent of 4.2%.
ž Next, look at ICOR. How to calculate it?

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ž ICOR= Incremental capital output ratio= Gross
capital formation/ Output growth
ž = 35/6.2
ž =5.64
ž Appears that our ICOR has increased.
ž Look at 2012-13. What data do we have?
ž We have- output growth rate =5%, CAD=4.8 and
ICOR (previous year)= 5.64. Use this to calculate
domestic savings rate.
ž I/O=5.64
ž But I=Gross dom svgs + external savings= x+4.8

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ž X+4.8= 5.64* 5
ž X=28.2- 4.8= 23.4

ž i.e. it appears that domestic savings has

fallen from 30.8 to 23.4.
ž Unless dom savings is increased, we may not
be able to achieve growth.
ž Using external savings to finance growth has
its own implications, which we study later.

Dr. Tulsi Jayakumar 12

ž What are they?
ž Why do they occur?

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ž Refers to the fluctuations in the economic
activity around the path of trend growth.
ž What are bus cycles
ž Occur due to difference between actual
output and potential output.
ž Characteristics -Read Text- (are irregular and
unpredictable, associated with fluctuations
in all macro variables,…..)

Dr. Tulsi Jayakumar 14