Relationship Among Saving, Investment and Trade Cycle

Read this article to learn about the relationship among saving, investment, and trade cycle.

It would be quite proper to see whether the analytical apparatus given above regarding saving and investment equality can be fitted without strain, into the familiar sequence of events of the Trade Cycle.

In other words, can it explain why and how, inflation seems to breed deflation and deflation breeds inflation?

We have known that the volume of savings depend partly upon the propensity to save and partly upon the size of the national income—that is, on the state of trade, the volume of investment depends partly upon the state of trade and partly on other factors, of which the rate of interest charged upon borrowed money is the most important; and the state of trade depends upon the relationship between saving and investment.

At first sight it might appear that we have got into an impasse, for the state of trade appear both as cause and as effect. However, it is precisely this complex relationship that enables us {o understand the phenomenon of trade cycle. Any explanation of trade cycle in terms of saving and investment must take into account three facts.

Firstly, saving and investment must be able to explain that why both inflation and deflation are, to begin with, cumulative, they nevertheless alternate—that is to say, each first feeds on itself but later gives birth to the other.

Secondly, it must explain the fact that alternation occurs at fairly regular intervals.

Thirdly, it must explain the fact that the transformation from boom to slump is violent and sudden while the contrary change at the bottom of the slump, from which recovery emerges, is very slow and gradual.

Let us start with the assumption that saving has come to exceed the investment (S > I). As a result there is a gap in the circular flow of money and economic activities, demand is below what would be necessary to buy the goods and services produced; consequently, the level of economic activity is falling. The fall in the community’s income will reduce the volume of savings and this in turn will reduce the volume of investment.

Thus, saving and investment both fall together and there appears to be no tendency for the disequilibrium between them to disappear. As the income declines further, the more rapid will be the decline in savings. In other words, the bigger the fall in income, the faster is the reduction in savings and this further depresses investment.

In boom periods businessmen pile up heavy stocks of raw materials and it has been often observed that in the early part of depression the gradual liquidation of these stocks is an important cause of ‘disinvestment’. When it has been finished, because stocks have been reduced to the minimum necessary for carrying on business, one reason for the decline in investment is removed. Moreover, there are at times certain projects of investment—like the renewal of plant or a programme of public works.

Thus, if the community income goes on falling, a point must come at which saving, in its fall overtakes investment. The trend once having been reversed, saving and investment will tend to chase each other in an upward direction. Each increase in investment will increase the national income and diminish unemployment. It is true that part of the increased income will be saved but a greater part will be spent on consumption making new investments more profitable.

The community is now in very happy position of being able both to spend more and to save more. The increasing volume of investment requires more volume of money creation by banks and if banks are unable to meet the demands of increased credit and refuse new advances, the rate of interest will go up and the volume of investment will be choked off. But the inelastic supply of money is not the only factor which will bring the upward phase of the trade cycle to an end, if it goes on long enough, it is bound to collapse of its own weight.

The community can both consume and spend more as long as there are unemployed resources of labour and capital, whose reemployment increases the national income both in money and real terms. But as soon as full employment is reached, this is no longer possible and if investment is still increasing it will only intensify the boom. Thus, inflation, like deflation tends for a time to intensify itself.

The tendency that there is a sharp reversal at the top and gradual one at the bottom can be explained when it is kept in mind that the predominant part in the movements of the trade cycle is played by the volume of investment, which in turn, depends upon the psychology, confidence and expectations of businessmen. People can be scared quickly but the restoration of confidence is a much slower and painful process. It follows, therefore, that the governing factor in any particular trade cycle and the one factor that must be brought under control is the volume of investment.

It is necessary to maintain equilibrium between saving and investment at each stage of movement in the economy. This equilibrium is disturbed whenever the decisions of entrepreneurs in respect to investment and the decisions of the community in respect to saving are not in harmony.

This disequilibrium takes the form of the cumulative expansion of boom on the one hand and the cumulative contraction of slump on the other. Because the classical assumptions that this kind of disequilibrium is prevented from becoming serious by the operation of the interest rate have been shown to be unfounded, we have, therefore, an interesting possibility accounting for business cycles through variations of saving and investment.