Saving-Investment Controversy (With Explanation)

Saving-Investment Controversy:

To understand Keynesian income deter­mination theory, concepts of saving and investment are to be spelt out categorically.

This is because one encounters conflicting statements relating to saving and invest­ment. One statement says that saving and investment are always equal. Another statement says that saving and investment are equal only at the equilibrium level of income. This apparent contradiction will now be resolved here.

Aggregate income (Y) is the aggregate money value of all goods and services produced. For the sake of simplicity, we assume that a nation produces two types of goods—consumer goods (C) and investment goods (I). Or income is spent on buying consumption goods and investment goods. Thus, national income is the sum of consumption demand and investment demand, i.e.,

Y = C + I …(10.17)

Again, a part of income is consumed and the remainder of it is saved (S).

Thus,

Y = C + S

Or, C + I = Y = C + S

By cancelling out ‘C’ from both sides of the equation (10.20) we get

I = S …(10.18)

This equation states that investment and saving are always equal. It is a definitional identity or accounting identity rather than an equation since this saving-investment equality is always true.

However, one can argue that saving and investment are equal only at the equilibrium level. Hence the contradiction. To resolve this, concepts of actual saving (symbolized by S_A), actual investment (I_A), planned saving (S_p) and planned investment (I_P) may be introduced here.

The accounting identity between saving and investment is interpreted in actual or realized sense, i.e.,

S_A = I_A

On the other hand, economists use a set of equations that show planned saving and planned investment are equal, i.e.,

S_P = I_P

However, only at the equilibrium level of income S_p = I_p and they are unequal (S_p ≠ I_p) at disequilibrium level of income.

(a) Why S_A = I_A?

From the national income accounting system, it follows that S_A = I_A. Whenever these two are equal it is called an identity, rather than an equation. What people plan to do and what people succeed in their saving and investment activities may imply two different things.

By actual saving (or ex-post saving) and actual investment (or ex-post investment) we mean those which have already been achieved. The accounting identity shows how actual income is divided into actual saving and actual investment. Actual saving is the excess of actual consumption (C_A) over actual income (Y_A), i.e.,

S_A = Y_A – C_A …(10.19)

We know that aggregate output and aggregate expenditure or aggregate demands are equivalent. Thus, aggregate income or aggregate expenditure is the sum total of actual consumption expenditure and actual investment expenditure.

Thus,

Y_A = C_A + I_A …(10.20)

Or, Y_A – C_A = I_A …(10.21)

S_A = I_A …(10.22)

Thus, saving and investment are always equal if they are interpreted in actual or ex- post sense,

(b) Why S_P = I_P and S_P ≠ I_P?

When we say that saving and investment can be unequal then these two are interpreted in the planned sense or ex-ante sense. What the savers and investors plan to save and invest are called planned saving and planned investment. Economists talk of the saving- investment equality in planned sense.

Only at the equilibrium level of income planned saving is equal to planned investment. In terms of Fig. 10.12, at OY_e level of income, what the savers intend to save investors intend to invest—the same amount. In other words, when the planned saving and planned investment lines intersect each other at only one point, one can easily determine equilibrium level of income.

However, to the right or left of point E, S_P ≠ I_P. Whenever S_P > I_P income will tend to decline and whenever I_P > S_P income will tend to rise. Only at OY_e level of income is planned (desired) saving equal to planned (desired) investment.

Thus, the divergence between S_p and I_P causes a change in aggregate demand. To explain this, let us assume that households behave in such a way that actual saving and planned saving are equal. But the behaviour of firms is such that unplanned investment occurs through changes in inventories.

Let us suppose that

S_A = S_P > I_P

This means aggregate demand or expenditure falls short of aggregate output. Households, thus, purchase less resulting in an unanticipated piling up of inventories of unsold goods. Increase in inventories is tantamount to an increase in investment.

But such swelling of inventories is nothing but unplanned investment. Consequently, firms will cut down production. This will cause aggregate output or income and employment to decline until planned saving becomes equal to planned investment.

Conversely, when S_P < I_P, aggregate demand exceeds aggregate output, causing reduction in inventories in an unanticipated, unplanned manner. This is called disinvest­ment, a term opposite to investment. To prevent such reduction in inventories firms will increase output level. This will cause income and saving to rise until S_P = I_P.

Thus, at the equilibrium level of income, we obtain

I_P = I_A = S_A = S_P …(10.23)

Thus, planned saving and planned investments are equal only in equilibrium and unequal in disequilibrium. Why are the two unequal? According to Keynes, savers and investors are two different persons in the community and their behaviour is different.

In other words, motives of savers must be different from those of investors.

Thus, there is no reason to believe that what households want to save must be exactly the same amount what investors want to invest. There is no reason why desired saving should equal desired investment at any randomly chosen level of income, but when they are not equal in the two- sector economy, national income will change until they are brought into equal.

From now on, “We must avoid saying in the same breadth that saving and investment can only be equal and that saving and investment can be unequal. We can, however, flatly and unambiguously say that realized saving and realized investment can only be equal and that planned saving and planned investment can be unequal.” (E. Shapiro)