The Relationship between Saving and Investment (Explained With Diagram) (2024)

The Relationship between Saving and Investment!

An important controversy in macroeconomics relates to the relationship between saving and investment. Many economists before J.M. Keynes were generally of the view that saving and investment are generally not equal; they are equal only under condition of equilibrium. Besides, they thought that equality between saving and investment is brought about by changes in the rate of interest. Keynes in his famous work “General Theory of Employment, Interest and Money” put forward the view that saving and investment are always equal.

This gave rise to a severe controversy in economics as to whether saving and investment are always equal or they are generally unequal. This controversy has now been resolved, and there is general agree­ment among the economists about the correct relationship between saving and investment.

Mod­ern economists use the concepts of saving and investment in two different senses. In one sense, saving and investment are always equal, equilibrium or no equilibrium. In the second sense, saving and investment are equal only in equilibrium; they are unequal under conditions of disequilibrium. We shall explain below in detail the relationship between saving and investment in these two different senses.

When in a certain year there is net addition to the stock of capital, investment is said to have taken place. It is worth mentioning here that by investment we do not mean the stock of capital but the net addition to the stock of capital i.e., investment is a flow concept. Of course, addition to the stock of capital is made through the flow of investment. In every year stock of capital expands through net investment.

On the other hand, by saving we mean the part of the income which has not been spent on consumer goods and services. In other words, saving is the difference between income and consumption expenditure. It is worth noting that in consumption expenditure all types of expenditure are not included. If an individual spends a part of his income on providing irrigation facilities, on buying tools and machinery, then that expenditure is not the consumption expenditure, it is in fact an investment expenditure.

In order to obtain the saving, we have only to deduct the consumption expenditure from income and not the investment expenditure. When an individual makes investment expenditure he is deemed to spend his saved income on investment. For instance, if a farmer’s annual income is Rs. 10,000 and he spends Rs. 6,000 on consumer goods and services and spends Rs. 1,000 on the construction of a well for his fields, and another Rs. 1,000 on building a drainage system for his fields and providing fencing, then his saving would be 10 – 6 = Rs. 4 thousands.

The expenditure of Rs. 2,000 on well, drainage and fencing will be included in the saving and will not constitute the consumption expenditure. If Y represents the national income of a country and C the total consumption, then the saving of the country will be equal to Y – C. Thus,

S = Y – C

Ex-post Savings and Ex-post Investment are always equal:

Pre-Keynesian economists were of the view that savings and investment are generally not equal. This is firstly because saving and investment are made by two different classes of people. While investment is undertaken by entrepreneurial class of the society, saving is done by the general public. Secondly, saving and investment depend upon different factors and are made for different purposes and motives.

Therefore, it is not inevitable that savings and investment of a society must always be equal. Besides, some pre-Keynesian economists pointed out that invest­ment expenditure is also undertaken by borrowing money from the banks which create new credit for this purpose.

It was thus pointed out that more amount of investment than savings is possible because excess of investment over savings is financed by new bank credit. But Keynes expressed a totally opposite view that saving and investment are always equal. The sense in which savings and investment are always equal refers to the actual savings and actual investment made in the economy during a year.

They are also called ex-post saving and ex-post investment. If we have to calculate that during the year 2002-03, how much actual savings and investment have been made in India, we will have to deduct the total consumption expenditure made by the citizens of India during that year from the national income.

Likewise, the real investment during the year 2002-03 of the Indian economy will be obtained by summing up the investments actually made by the Indian people during that year. In fact, national income estimates of savings and investment are made in this actual or ex-post sense.

The second sense in which saving and investment words are used is that in a certain year how much saving or how much investment people of the country desire or intend to do. There­fore, saving and investment in this sense are known as desired, intended or planned savings and investment. They are also called ex-ante saving and ex-ante investment.

Keynes in his book, “General Theory of Employment, Interest and Money” showed that in spite of the fact that saving and investment are done by two different classes of people and also for different purposes and motives, actual saving and actual investment are always equal.

Thus, he used the word saving and investment in the ex-post or actual sense and proved the equality between saving and investment in the following way:

Income of a country is earned in two ways:

(1) By producing and selling consumer goods and services, and

(2) By producing and selling capital goods.

That is, national income of a country is composed of the value of consumer goods and services and the value of capital goods.

This can be expressed in the form of the following equation:

National Income = Consumption + Investment

or

Y = C + I

where Y stands for national income, C for consumption and I for investment.

The above equation represents the production or earning side of the national income. The second aspect of national income is the expenditure side. The total national income can be fully consumed but generally it does not happen so. In actual practice, a part of the total income is spent on consumption and the remaining part is saved.

From this we get the following equation:

National Income = Consumption + Saving

Or

Y = C + S

where Y stands for national income, C for consumption and S for saving.

In the above two equations (i) and (ii) it is clear that national income is equal to the sum of consumption and investment and also equal to the sum of consumption and saving.

From this it follows that:

Consumption + Saving = Consumption + Investment

C + S = C + I

In equation (iii) above, since C occurs on both sides of the equation, we get:

Saving = Investment

or

S = I

From the foregoing analysis, it follows that saving and investment are defined in such a ay that they are necessarily equal to each other. In equation (i) investment is that part of national income which is obtained from the production of goods other than those consumed and equation (ii) saving is that part of national income which is not spent on consumption.

Hence the actual or ex-post sense, saving and investment by definition are equal. It is worth mentioning that in macroeconomics, saving and investment do not refer to the saving and investment by an individual; they refer to the saving and investment of the whole community or economy. Saving and investment by an individual can differ but in the ex-post sense, the saving of the whole country must always be equal to the investment.

Now the question arises, why ex-post saving and ex-post investment are always equal. For instance, when more investment is undertaken by the entrepreneurs how actual saving becomes equal to this larger investment and if the saving falls how investment will become equal to smaller savings. In this connection it is worth mentioning that modern economists, as did Keynes, include the addition to the inventories of consumer goods in investment.

Now, when saving increases, it implies that consumption will be less. The decline in consumption would result in the addition to the inventories of consumer goods with the shopkeepers and manufacturers, which were not planned or intended by them. This addition to inventories, though unintended, will raise the level of actual investment.

Thus unintended increase in inventories will raise the level of investment and in this way investment will increase to become equal to the greater saving. On the other hand, if in any year saving declines, it will result in the unplanned decline in the inventories of consumer goods with the traders and manufacturers. This unintended decline in inventories will mean the fall in actual investment. In this way, investment will decline to become equal to the lower savings.

Ex-ante saving and Ex-ante Investment are Equal only in Equilibrium:

As said above, in the desired, planned or ex-ante sense, saving and investment can differ. In fact planned or ex-ante saving and investment are generally not equal to each other. This is due to the fact that the persons or classes who save are different from those who invest.

Savings are done by general public for various objectives and purposes. On the other hand, investment is made by the entrepreneurial class in the community and is generally governed by marginal efficiency of capital on the one hand and rate of interest on the other hand.

Therefore, savings and investment in planned or ex-ante sense generally differ from each other. But through the mechanism of change in the income level, there is tendency for ex-ante saving and ex-ante investment to become equal.

When in a year planned investment is larger than planned saving, the level of income rises. At a higher level of income, more is saved and therefore intended saving becomes equal to intended investment. On the other hand, when planned saving is greater than planned investment in a period, the level of income will fall.

At a lower level of income, less will be saved and therefore planned saving will become equal to planned investment. We thus see that planned or ex-ante saving and planned or ex-ante investment are brought to equality through changes in the level of income. When ex-ante saving and ex-ante invest­ment are equal, level of income is in equilibrium i.e., it has no tendency to rise or fall.

It is thus clear that whereas realised or ex-post saving is equal to realised or ex-post investment, intended, planned or ex-ante saving and investment may differ; intended or ex-ante saving and investment have only a ten­dency to be equal and are equal only at the equi­librium level of income.

That the planned or intended saving is equal to intended investment only at the equilibrium level of income can be easily understood from Fig. 8.3. In this figure, national income is measured along the X-axis while saving and investment are measured along the Y-axis.

SS is the saving curve which slopes upward indicating thereby that with the rise in income, saving also increases. II is the investment curve. Investment curve II is drawn as horizontal straight line because, following Keynes, it has been assumed that investment is independent of the level of income i.e., it depends upon factors other than the current level of income.

It will be seen from the Fig. 8.5 that saving and investment curves intersect at point E. Therefore, OY is the equilibrium level of income. If the level of income is OY₁, the intended investment is Y₁H whereas the intended saving is Y₁L. It is thus clear that at OY₁ level of income, intended investment is greater than intended saving.

As a result of this, level of income will rise and at higher levels of income more will be saved. It will be seen that with the rise in income to OY₂, saving rises and becomes equal to investment. On the other hand, if in any period, level of income is OY₃ intended investment is Y₃K and intended saving is Y₃J. As a result of this, level of national income will fall to OY₂ at which ex-ante saving and ex-ante investment are once again equal and thus level of national income is in equilibrium.

To sum up, whereas ex-post savings and ex-post investment are always equal, ex-ante saving and ex-ante investment are equal only in equilibrium.