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 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 … (3.17)
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 this equation, we get
I = S … (3.18)
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 (symbolised by SA), actual investment (IA), planned saving (Sp) and planned investment (Ip) may be introduced here.
The accounting identity between saving and investment is interpreted in actual or realised sense, i.e.,
SA = IA
On the other hand, economists use a set of equations that show planned saving (or ex- ante saving) and planned investment (or ex- ante investment) are equal, i.e.,
Sp = Ip
However, only at the equilibrium level of income Sp = Ip, and they are unequal (Sp ≠ Ip) at disequilibrium level of income.
1. Why SA = IA?
From the national income accounting system, it follows that SA = IA. Whenever these two are equal then 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 (CA) over actual income (YA), i.e.,
SA = YA – CA ……(3-19)
We know that aggregate output and aggregate expenditure or aggregate demand are equivalent. Thus, aggregate income or aggregate expenditure is the sum total of actual consumption expenditure and actual investment expenditure. Thus,
YA =CA + IA …(3.20)
or YA-CA=IA …(3.21)
Thus, saving and investment are always equal if they are interpreted in actual or ex- post sense.
2. Why Sp = Ip and Sp ≠ Ip?
When we say that saving and investment can be unequal then these two are interpreted in 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. 3.12, at OYF 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, Sp ≠ Ip. Whenever Sp > Ip income will tend to decline and whenever I p > Sp, income will tend to rise. Only at OYp level of income, planned (desired) saving is equal to planned (desired) investment. Thus, the divergence between Sp and Ip 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
SA = SP ˃ IP
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 are 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 Sp < Ip, 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 Sp = Ip.
Thus, at the equilibrium level of income, we obtain
Ip = 1A = SA = Sp … (3.23)
Thus, planned saving and planned investment 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 to being 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 realised saving and realised investment can only be equal and that planned saving and planned investment can be unequal.” (E. Shapiro)