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The saving and investment rate Essay

Investment is a major component of aggregate demand for countries of the developed world and plays a very important role in promoting faster rates of economic growth. “Investment permits more roundabout methods of production and increases in productivity thereby providing an additional future stream of income to society”1. Economic theory also illustrates that the level of investment and savings must be equal, although theory disputes how this is achieved. Classical theory assumes that this is achieved via changes in the rate of interest while Keynesian economic theory relies on the multiplier effect of changes in the level of income.

Most developing countries tend to have an abundant supply of labour and hence the limiting factor to the achievable level of output of a Less Developing Country (LDC) is that of capital. It is clear, therefore, that the rate of capital accumulation does govern the rate of economic development of a country and, therefore, it is no wonder that many development economists and theories have stressed the importance of increasing both the rate of saving and investment.

It is important to note, however, that investment can not only increase the level of total output of an economy but also the level of output

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per worker as capital accumulation helps to increase the size and productivity of the labour force allowing a more extensive division of labour. Having stressed the importance of increasing the saving and investment rate this essay aims to illustrate the methods through which this may be achieved, whilst acknowledging that a rise in the level of investment, although necessary is not sufficient condition for the successful promotion of economic development.

In order for a developing country to invest and acquire capital there must be a growing surplus of income above the current level of consumption which can be directed towards productive investment projects. In essence capital formation involves the following three essential steps. Firstly there must be an increase in the level of real savings so that resources can be made available to finance investment projects. These savings then need to be ‘channelled’ through a finance and credit mechanism, so that investors are able to make use of funds which may be collected from a diverse array of sources and would otherwise be unattainable.

Finally there the investment projects themselves need to be conducted with the resources being used to increase the size of the capital stock. It is also necessary that there is an increase in the volume of real savings so that there may be in an increase in the level of investment without the consequence of rising inflation and its associated costs. As point two above illustrates, however, the ‘channelling’ of savings is just as important in increasing their level.

It is for this reason, therefore, that development economists have stressed the need for the establishment of financial institutions, which can provide a convenient and safe method by which any savings that economic agents make can be allocated efficiently and effectively to the most productive uses. It is also stated that the need for such institutions is all the more important the poorer the country as the fund for investment projects must be attained from a larger population.

A common problem both empirically and relevant for current less developed countries has been that there has often been governmental opposition to such financial institutions and hence legal restrictions often hamper their operation. It is claimed that the success of Germany both today and during its process of industrialisation and development emanates from the German model of a financial system, but even this system faced initial opposition.

Originally the German financial institutions were some of the most primitive in Western Europe and provided very little in the way of investment loans. These institutions underwent radical changes from the 1840’s as a result of the rapid expansion and success of the railroads. There was much agitation during this period because “note-issuing banks which could provide capital raised by their operations to firms, particularly railway companies, which needed it was sternly opposed by the Prussian government.

The government was fearful of the loss of revenue from any infringement of its own minting rights, and was afraid of the effect which financial speculation might have on state finances”2. It was anxious that investment in railways might divert investment from the land driving down the value of estate mortgage bonds (Pfandbriefe). In 1846 the Royal Bank was converted into the Preussiche Bank which was a joint stock company with private capital and was also given the exclusive right of note issue, although this was under strict government supervision.

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