ABSTRACT
We remember that this equation is an ex-post identity, because, according to national accounting definitions, consumption (C), investment (I) and net exports (X - M) add up to national income (Y), which in tum is spent on consumption (C) and saving (S). In fact, it is common practice for national statistics bureaus to compute S as a residual by deducting foreign capital inflows from investments. In an ex-ante perspective, however, the equation is an equilibrium condition because it states that the difference between planned investments and planned savings equals the difference between planned imports and planned exports. The value of the difference between I and S is the investment-savings gap, and the one between M and X is the trade or foreign exchange gap. Both gaps are filled by the inflow of foreign capital (F). When the two gaps are simultaneously filled, based on planned savings, investments, imports and exports, then aggregate demand and supply are in equilibrium. Usually, however, the two gaps are not identical, so that economic growth is then constrained by the larger of the two gaps, and some resources of the non-binding constraint remain unused. Based on these concepts, we can now assemble the building blocks of a simple twogap model. The first component is the familiar assumption about the behavior of domestic savers written as:
where F is foreign saving, equal to net capital inflows. If we ignore for a moment the existence of imports, exports and their relationship with national income, assuming that the capital inflow will simply fill the savings gap, we can compute the growth rate based on internal equilibrium. Combining the equations 4.2 to 4.4, by substituting 4.4 and 4.2 into 4.3 and dividing by Y, we solve for the GDP growth rate gy = ~YN:
where f = FlY is the capital inflow expressed as a proportion of national income or GDP. We shall call this rate the savings-constrained growth rate (gs), replacing the subscript Y by the subscript s. This growth rate is identical to the Harrod-Domar growth rate, with the only exception that the proportion of foreign capital inflow adds to the savings ratio.
