Two instrumental sources of economic growth are increases in the skills and knowledge of the workforce, known as human capital, and increases in capital—goods used to make other goods—which can also be called physical capital to distinguish it from human capital. Human capital is largely provided by the government through public education. (In countries with a large private education sector, like the United States, private post-secondary education is also an important source of human capital.) But physical capital, with the exception of infrastructure such as roads and bridges, is mainly created through private investment spending—that is, spending by firms rather than by the government.

Who pays for private investment spending? In some cases it’s the people or corporations who actually do the spending—for example, a family that owns a business might use its own savings to buy new equipment or a new building, or a corporation might reinvest some of its own profits to build a new factory. In the modern economy, however, individuals and firms who create physical capital often do it with other people’s money—money that they borrow or raise by selling stock. If they borrow money to create physical capital, they are charged an interest rate. The interest rate is the price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year.

To understand how investment spending is financed, we need to look first at how savings and investment spending are related for the economy as a whole.

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The most basic point to understand about savings and investment spending is that they are always equal. This is not a theory; it’s a fact of accounting called the savings–investment spending identity.

To see why the savings–investment spending identity must be true, first imagine a highly simplified economy in which there is no government and no interaction with other countries. The overall income of this simplified economy, by definition, would be equal to total spending in the economy. Why? Because the only way people could earn income would be by selling something to someone else, and every dollar spent in the economy would create income for somebody. So, in this simplified economy,

(22-1) Total income = Total spending

Now, what can people do with income? They can either spend it on consumption or save it. So it must be true that

(22-2) Total income = Consumer spending + Savings

Meanwhile, spending consists of either consumer spending or investment spending:

(22-3) Total spending = Consumer spending + Investment spending

Putting these together, we get:

(22-4) Consumer spending + Savings = Consumer spending + Investment spending

Subtract consumer spending from both sides, and we get:

(22-5) Savings = Investment spending

As we said, then, it’s a basic accounting fact that savings equals investment spending for the economy as a whole.

So far, however, we’ve looked only at a simplified economy in which there is no government and no economic interaction with the rest of the world. Bringing these realistic complications back into the story changes things in two ways.

First, households are not the only parties that can save in an economy. In any given year, the government can save, too, if it collects more tax revenue than it spends. When this occurs, the difference is called a budget surplus and is equivalent to savings by the government. If, alternatively, government spending exceeds tax revenue, there is a budget deficit—a negative budget surplus. In this case, we often say that the government is “dissaving”: by spending more than its tax revenues, the government is engaged in the opposite of saving. We’ll define the term budget balance to refer to both cases, with the understanding that the budget balance can be positive (a budget surplus) or negative (a budget deficit). National savings is equal to the sum of private savings and the budget balance, whereas private savings is disposable income (income after taxes) minus consumption.

Second, the fact that any one country is part of a wider world economy means that savings need not be spent on physical capital located in the same country in which the savings are generated. That’s because the savings of people who live in any one country can be used to finance investment spending that takes place in other countries. So any given country can receive inflows of funds—foreign savings that finance investment spending in the country. Any given country can also generate outflows of funds—domestic savings that finance investment spending in another country.

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The net effect of international inflows and outflows of funds on the total savings available for investment spending in any given country is known as the capital inflow into that country, equal to the total inflow of foreign funds minus the total outflow of domestic funds to other countries. Like the budget balance, a capital inflow can be negative—that is, more capital can flow out of a country than flows into it. In recent years, the United States has experienced a consistent net inflow of capital from foreigners, who view our economy as an attractive place to put their savings. In 2012, for example, capital inflows into the United States were $446 billion.

It’s important to note that, from a national perspective, a dollar generated by national savings and a dollar generated by capital inflow are not equivalent. Yes, they can both finance the same dollar’s worth of investment spending, but any dollar borrowed from a saver must eventually be repaid with interest. A dollar that comes from national savings is repaid with interest to someone domestically—either a private party or the government. But a dollar that comes as capital inflow must be repaid with interest to a foreigner. So a dollar of investment spending financed by a capital inflow comes at a higher national cost—the interest that must eventually be paid to a foreigner—than a dollar of investment spending financed by national savings.

So the application of the savings–investment spending identity to an economy that is open to inflows or outflows of capital means that investment spending is equal to savings, where savings is equal to national savings plus capital inflow. That is, in an economy with a positive capital inflow, some investment spending is funded by the savings of foreigners. And, in an economy with a negative capital inflow (a net outflow), some portion of national savings is funding investment spending in other countries. In the United States in 2012, investment spending totaled $2,475.2 billion. Private savings were $1,491.7 billion, offset by a budget deficit of $1,109.7 billion and supplemented by capital inflows of $446 billion. Notice that these numbers don’t quite add up; because data collection isn’t perfect, there is a “statistical discrepancy” of $17 billion. But we know that this is an error in the data, not in the theory, because the savings–investment spending identity must hold in reality.