Equilibrium Relations between Income, Saving and Investment (2024)

Read this article to learn about the0 equilibrium relations between income, saving and investment!

Equality between saving and investment is regarded as an essential condition of equilibrium level of income, output and employment by Keynes as well as classical economists.

But, their approach and views regarding the phenomenon are altogether different and controversial.

The Classical View:

The classical economists believed in the economy’s equilibrium at full employment level. In their view, saving- investment equality is brought about by the mechanism of the rate of interest. Rate of interest, thus, is regarded as a strategic variable.

The classicists held that if saving and investment are equal at a time, they will be soon brought into equilibrium by automatic changes in the rate of interest. Given the rate of investment, if saving increases, then the rate of interest will fall.

With the decline in the rate of interest, investment demand will rise. But the fall in the rate of interest will affect the volume of saving adversely. Hence, through expansion in investment and contraction in saving, ultimately, equality between saving and investment will be brought about.

The rate of interest will change so long as increased saving is reduced and investment is increased to attain an equilibrium point. Conversely, when saving decreases, the rate of interest will rise to boost saving and curtailed investment is achieved. Thus, to the classicists, the rate of interest is the equilibrating variable between saving and investment.

Moreover, the classical economists visualised equality between saving and investment at a point of full employment only. Thus, the classical notion of monetary equilibrium is one in which savings flow automatically into an equal amount of investment via changes in the interest rate to give full-employment level of income.

In fact, the classical notion is about a special full- employment equilibrium in which investment equals saving only at full employment and the equilibrating variable is the rate of interest.

The Keynesian View:

Keynes too stressed in his General Theory that aggregate investment always equals aggregate saving. He, however, presented an entirely different theory from that of the classicists in this issue. He rejected the classical postulate of the rate of interest being a strategic or equilibrating variable in bringing about the equality between investments and saving at full employment level.

According to Keynes, the saving-investment equality is a condition of equilibrium at any level of employment, and not necessarily always the full employment level. More realistically, it is usually at less than full employment level.

Again, savings and investment are brought into equality by income changes. Thus, Keynes put forward a revolutionised idea by treating the level of income rather than the rate of interest as the strategic or equilibrium variable which effectuates saving-investment equality.

Keynes analysed the saving-investment equality on two counts:

(1) Accounting equality, and

(2) Functional equality.

Accounting Equality:

In the matrix of any national income accounting, it will be observed that actual savings and actual investment are always identically equal. This “accounting” equality of savings and investment obviously follows when saving for national economy as a whole is defined as the aggregate of savings in the various sectors of the economy (firms, households and government) in the form of excess of current income over current consumption, the current investment being that part of current income which is spent not for the purpose of consumption but for producing further goods.

Thus, there is an inevitable consistency between realised saving and investment in national income accounts because total income in a given period equals the total output, and in a matrix, income that is not spent on goods (i.e., saving) is identical in size with the quantity of goods produced which are not bought with current income (i.e., investment) briefly thus:

Income = consumption plus saving.

Output = consumption plus investment.

But income = output.

Investment = saving.

In the national investment income accounts, therefore, saving is numerically identical with investment.

It seems that Keynes thought of such accounting identity of saving and investment when he remarks in his General Theory: “Saving and investment are necessarily equal in amount for the community as a whole, being merely different aspects of the same thing.” Keynes states that “saving” and “investment” are not only equal but also identical.

He defined saving as the excess of income over consumption. He defined investment as the increment of capital equipment or in other words, the addition which is made to the stock of real capital. The addition which is made to the stock of real capital is represented by the unconsumed output in a given period.

Thus, the unconsumed output in the current period is the current investment in real terms. In money terms, therefore, current investment is equal to the value of that part of current output which is not consumed. To Keynes, income is equal to the value of current output.

Since investment causes an increment in capital equipment, which, in other words, is an addition made to the stock of real capital, this addition represents the unconsumed output in a given period. In other words, it is known as current investment. This current investment in money terms therefore is equal to the value of that part of current output which is not consumed. Hence, Keynes concludes that income is equal to the value of current output. In short,

Income = Value of output = Consumption + Investment.

Saving = Income – Consumption

Saving = Investment.

Symbolically, saving and investment equality can be proved as under:

S = Y – C. Y = С + I.

I = Y – C.

Since Y – С is common to both, therefore, S = I.

or, alternatively,

Y = С + I;

Y = С + S, but S = Y – С

By substituting the value of Y as С + I, we get,

S = (C + I) – С

S = С + I – С,

S = I.

However, it should be noted that while investment and saving are always equal, they are not always in equilibrium. The definitional equality of S and I does not imply that they are not necessarily in equilibrium.

The accounting equality of saving and investment holds good regardless of whether the economy is in or out of equilibrium, that is, whether national income is in or out of equilibrium or whether national income is constant or changing. On this issue, to some critics, saving-investment identity is merely a truism. It reveals no casual relations. The so-called accounting equality between saving and investment is almost meaningless when it is not related to equilibrium.

In this context, Prof. Kurihara rightly points out that the economic significance of this accounting equality of S and I lies in the fact that it shows the condition that must be satisfied in order to reach the equilibrium level of income, that is, a condition characterised by the quality of planned S and I as against equal or realised S and I. Moreover, the accounting equality of saving and investment also implies that the determinants of consumer and entrepreneurial behaviour have to be investigated when the entire economy is temporarily in disequilibrium.

Functional Equality:

Since the “accounting” equality of saving and investment represents the statistical result of the behaviour of the entire economic system in a given period, the concepts of saving and investment seem to be only static. But Keynes’ modern economic analysis also conceived the “functional” equality of saving and investment which emphasises the behaviour of the economy as a whole, and thus, saving and investment concepts become dynamic.

Moreover, in the definitional equality of saving and investment, there is absence of the equilibrating variable. Thus, it has been a tool of static analysis. Keynes conceived the functional equality of saving and investment and introduced income as the equilibrating variable.

According to Keynes, in the functional or scheduled sense, there is the saving schedule and investment schedule and the equality between investment and savings is a consequence of changes in the level of income. To him, equality between saving and investment function is an indispensable condition of equilibrium.

No level of national income can be sustained without the equality of aggregate saving and aggregate investment. And he stressed the point that income is the functional variable that brings about equality between saving and investment.

In his concept of functional equality of saving and investment, savers and investors react to income variations in such a way that their desire to save and to invest is expected to be harmonised in the very process of these reactions.

Thus, if saving exceeds investment (that is to say, when investment decreases), saving remaining constant (because the saving schedule is a stable function of income), income will fall and, therefore, saving will also contract. Income will continue to fall until the saving out of the lower income is equal to the reduced investment.

Similarly, if investment increases, saving remaining constant (thus, investment exceeding saving), income will rise until the saving out of the higher income is equal to the increased investment. It should be noted that when investment exceeds saving, that is, when investment increases, a new equilibrium between saving, and investment will materialise at a higher level of income; and when saving exceeds investment, that is, when investment decreases, the new equilibrium of saving and investment will be at a lower income level.

Hence, Keynes considered shifting equilibrium in his income analysis in terms of saving and investment equality as against the traditional analysis of full employment equilibrium in which investment can be and normally are equal to each other at the point of less than full employment.

Saving-investment Relations:

In Keynes’ view, investment does not depend significantly upon the level of income. It mainly depends on dynamic factors such as population growth, territorial expansion, progress of technology and above all, business expectations of the entrepreneur. Thus, it is unpredictable, unstable and autonomous as against savings which is stable, predictable and induced. Thus, it is fluctuations in investment that cause variations in income which in turn bring about equality between saving and investment.

According to Keynes, varying levels of income cannot be sustained in an economy unless the amounts of savings at these levels of income are offset by an equivalent amount of investment. Thus, Keynesian theory draws the equilibrium relations between income, saving and investment.

According to Keynes, varying levels of income cannot be sustained in an economy unless the amounts of savings at these levels of income are offset by an equivalent amount of investment. Thus, Keynesian theory draws the equilibrium relations between income, saving and investment. It stresses that the equilibrium level of income is realised where saving out of income is just equal to the actual amount of investment. This is depicted in Fig. 1.

In Fig. 1, II is the original investment schedule which is a horizontal straight line showing that investment is completely autonomous in the sense that it does not vary much with income. This is the fundamental postulate of Keynesian theory. I₁ is the new investment schedule indicating a shift in the I-function due to the forces of certain dynamic factors.

The curve SS is the saving schedule showing how the amount of saving increases with income. But, it is a stable phenomenon and, therefore, usually, there cannot be a shift in its curve. From the diagram it appears that the income is determined by the saving and investment schedules. Initially, I-schedule and S-schedule intersect at point E, and we have an income level OY, where obviously S=I. Thus, the Keynesian theory of shifting equilibrium shows the S and I equality at varying levels of income.

Of course, the Keynesian formulation of saving- investment relationship in its functional sense admits the divergences between saving and investment, but only at virtual levels and not at observable levels of income. The equilibrium level of national income is obviously the observable level of income where there is corresponding equality between “observable” savings and “observable” investment.

And, for given sayings and investment schedules, there is of course only one equilibrium level of income corresponding to the equality between S and I. In a static Keynesian system, there can be divergence between savings and investment only when the economy is not in equilibrium.

Thus, it should be noted that Keynes explained saving and investment relations in terms of schedule relation. His equation of S = I is analogous to that of the supply and demand equation (S=D) in ordinary markets. In the same way, Marshall’s supply and demand curves are important to the price theory.

Equality between the two (S and I) is regarded as an indispensable condition of equilibrium, and their equality is brought about through this variation in income level. Thus, his real contribution to economic thinking was to change the equilibrating variable from the interest rate to the level of income.