Consumption, savings, investments in the system of macroeconomic equilibrium

As already noted, consumption and investment are important components of aggregate demand, with savings having a significant impact on investment.

Investment is usually understood as the use of savings in order to create new production capacities and capital assets. When determining the content of investments, economic and financial aspects are usually distinguished.

The economic content of investments is expressed in the use of savings for the creation, expansion and technical re-equipment of fixed capital, as well as for related changes in working capital.

Based on the economic content of investments, it is possible to determine their directions:

construction of new industrial buildings and structures; procurement of new equipment, machinery and technology; additional purchases of raw materials; construction of housing and social facilities.

Accordingly, these areas distinguish types of investments:

productive investments; investment in inventories; investments in housing construction.

Financial investments are investments in stocks, bonds, bills of exchange and other securities and financial instruments. They form additional sources of expansion of real investments.

The essence of investments was considered by us quite fully in the course “Microeconomics”. Here we will focus only on the problem of the relationship between savings, investment and the equilibrium volume of GNP.

It should be noted that savings and investment affect the volume of effective demand in exactly the opposite directions: savings reduce demand, and investment increases it.

The level of investment has a significant impact on the national income of society; its dynamics will determine the many macro-proportionalities in the national economy. Keynesian theory emphasizes the fact that the level of investment and the level of savings (i.e., the source, or reservoir of investment) are determined largely by different processes and circumstances.

Investments  on a national scale determine the process of expanded reproduction. The construction of new enterprises, the construction of residential buildings, the laying of roads, and consequently, the creation of new jobs depend on the process of investment, or capital formation. As you know, the source of investment is savings. But the problem is that savings are carried out by some economic agents, and investments can be made by completely different economic entities.

The savings of the general population are a source of investment. But these persons (“savers”) do not carry out capital formation associated with a real increase in capital goods. Of course, the source of investment is also the accumulation of functioning various firms. Here, “saver” and “investor” coincide. However, the role of the savings of wage earners who are not also entrepreneurs is very significant, and the mismatch between the processes of saving and investing due to these reasons can lead the economy to a state that deviates from equilibrium.

Using graphical analysis, let’s try to find out how savings and investments affect the amount of GNP (GDP) and, consequently, the macroeconomic equilibrium. Let’s show on the abscissa axis the level of gross national product (GNP), on the axis of ordinate – savings and investment (Fig. 8.10).

Suppose that the investment is equal to 20 billion dens. units per year, regardless of the size of GNP. Since the amount of investment is unchanged, the investment schedule will take the form of a horizontal straight line, parallel to the GNP line. Now let’s enter here a graph of the population’s savings, presenting it in the form of a straight line.

A pertinent question is: at what level of GNP will the balance between II and SS (investment and savings) be established? Graphical analysis suggests that the savings chart intersects the investment chart at point E, where the amount of GNP is equal to OM. At point E – the point of intersection of two charts – savings and investments are equal to each other. Hence, it is a point of equilibrium. It characterizes such a volume of GNP at which macroeconomics is in a state of equilibrium. Why would the equilibrium state of GNP be at point E, where investment equals savings? When the equilibrium state is at point E, it means that the population will save in the amount of EM, and firms will invest in the amount of EM.

If the savings of the population are larger, i.e. move to point K, which will correspond to the size of GNP = OM1, then there comes a situation when savings are greater than investments. At this level of GNP, the population begins to save more than enterprises are willing to invest. In fact, the population refrains from additional consumption. As a result, firms find much less demand for additional products on the market and are forced to accumulate inventories. Naturally, this will not stimulate the growth of production and investment. Production begins to decline, which causes a decrease in GNP and leads it to a shift to the left. Employment of the population is decreasing, savings are decreasing. And this will happen until equilibrium is reached at the E-point, then the downward trend in GNP will cease.

If the savings of the population are smaller, i.e. move to point A, where the size of GNP = OM2, then there is a situation when savings are less than investments. Here, the population saves less, but firms are ready to invest.

In fact, we are talking about the fact that the population, reducing savings, makes a greater demand. This stimulates firms to increase production volumes, the production of additional products, which affects the growth of GNP and employment growth. Incomes of the population begin to grow along with the growth of GNP, and savings become more. And such growth will continue until equilibrium is reached at point E.

So, only at point E will such a size of GNP be achieved that it does not lead to fluctuations in the macroeconomic system, that is, there will be no sharp expansion, no sharp compression of the system, no overproduction, no shortage of goods. The equilibrium state of savings and investment at point E will determine the optimal amount of GNP at which macroeconomics will be in equilibrium.

It was noted above that savings are in close relationship with consumption and they represent a mirror image of each other. The question arises: is it possible to determine the optimal amount of GNP through the mechanism of consumption and investment? Let’s try to answer it.

Let’s recall the consumption schedule and try to apply it to our conditions. On the axis of the abscissa we will lay down the amount of GNP, and on the axis of the ordinate – the total expenditures, which are the sum of the expenditures of firms and the population, i.e. the amount of investment and consumption. The state in which the entire amount of GNP produced will be consumed by the population and firms, i.e. will be equal to their expenses, can be graphically depicted as a straight line running from the abscissa axis at an angle of 45 °. At any point in the 45° line, the costs are equal to the GNP at that point (Figure 8.11).

Now let’s enter here the consumption graph in the form of a straight line – SS. Point B shows the state when the income of the population is equal to its consumption. With an income value equal to OM1, the population consumes them completely, i.e. OM1 = VM1.

It is known that if the population demands mainly for consumer goods, then firms carry out the costs of buying new machinery, equipment, materials that are necessary for the expansion of production. As a result of these purchases, market demand expands by a value of I. Total expenditures will be equal to household consumption and investment (C + I). The direct total cost (C + I) will be raised above the direct HS by the amount of investment.

At point E, an equilibrium is reached at which the GNP-OM value is optimal, i.e. the entire product produced will be demanded by the population and firms. The length of the EM segment will be equal to the total costs, i.e. the sum of consumption and investment. The E-point on the 45° line shows the equality: OM = EM, or the equality of total costs and GNP.

If the amount of GNP is equal to OM3, which corresponds to the point F on the line of 45 °, then part of the products produced will not be sold, since the size of GNP will be greater than the estimated expenditures of the population and firms. Production will be reduced to point E. If the value of GNP is less than the level of estimated expenditures of the population and firms, this means that the quantity of goods is not equal to the corresponding demand, and consequently, to employment and the size of GNP up to the level of OM.

In this case, AD < AS. Unsold products take the form of inventories, which increase. The growth of inventories forces firms to reduce production and employment, which ultimately reduces GNP to the level of OM, where income and planned expenditures are equalized. Accordingly, an equilibrium of aggregate demand and aggregate supply is achieved, i.e. AD = AS.

Conversely, if the actual output of OM1 is less than the equilibrium OM, it means that firms produce less than buyers are willing to purchase, i.e. AD > AS. The increased demand is met by unplanned reductions in firms’ inventories, which creates incentives to increase employment and output. As a result, the GNP gradually increases to OM and the AD = AS equilibrium is reached again.

To avoid significant losses from the decline in production, an active state policy is needed to regulate aggregate demand.

If the state not only stimulates private investment, but also carries out a whole set of different expenditures, then the direct C + I will turn into a direct C + I + G, where G is public spending. Figure 8.11. is a clear illustration of the beneficial role of public spending and the stimulation of private sector investment, to which J. S. Miller attached great importance to the role of public spending and investment in the private sector. Keynes.

If we compare the two methods (the method of saving and investment and the method of consumption and investment) of determining the optimal amount of GNP, in which the economy is in a state of equilibrium, we will see that the optimal value of GNP in both cases will be the same. This equality derives from the correspondence of consumption and saving schedules.

Increased investment leads to an increase in GNP and contributes to the achievement of full employment also by virtue of a certain effect, which is reflected in economic theory called the multiplier effect. The multiplier represents a numerical coefficient that shows the increase in income growth over the growth of investments. The multiplier effect in a market economy is that an increase in investment leads to an increase in gross national product, and an amount greater than the initial growth in investment. Figuratively speaking, we can say that just as a stone thrown into the water causes circles on the water, so investments “thrown” into the economy cause a chain reaction in the form of an increase in income and employment.