The savings-investment spending identity is a key concept in macroeconomics that establishes the relationship between total savings and total investment in an economy. It simply states that total savings must equal total investment. This means that every dollar that is saved is invested in things like factories, equipment, housing, etc.
The identity arises because of the circular flow of money in an economy. Household savings flow to firms and governments, who use those funds for investments. The funds then cycle back to households in the form of income. So savings lead to investments which lead to income and consumption.
Understanding this core identity is crucial for analyzing the impact of policies on an economy’s output and financial markets. For example, policies that encourage savings will also boost investment, contributing to economic growth. The identity also links decisions of individual economic units to economy-wide outcomes.
Savings equals investment is an accounting identity, not a behavioral theory
The savings-investment identity should not be confused with theories about household savings behavior or firms’ investment behavior. It does not state that households intentionally save in order for those savings to be used for investment. Rather, it is simply an accounting identity – a mathematical equivalence that must hold due to the circular flow of funds in an economy. So it reflects an inevitable equality, not a causal theory about economic decision-making.
The identity holds for the economy as a whole, not necessarily for subgroups
While total savings must equal total investment for the economy overall, this does not mean that the savings of any particular group are funding that group’s investments. For example, households do most of the saving, while firms and governments do most of the investing in economies. So one group’s saving allows a different group’s investing.
It links financial markets with the real economy
Changes in savings and investment impact important variables like interest rates, economic growth, employment levels, and incomes. So the identity provides insight into the transmission mechanism between decisions in financial markets and outcomes in the real production economy. As such, it is an important concept for policymakers to understand.
The identity assumes a closed economy with no international trade
The savings-investment identity holds most accurately for a closed economy that does not interact with the rest of the world. This is because funds can flow into or out of an open economy, breaking the strict equality between domestic savings and investment. With globalization, very few economies are completely closed today. So economists sometimes talk about revisions to the identity for an open economy.
In summary, the savings-investment spending identity is a key macroeconomic relationship showing that total savings must equal total investment in an economy due to the circular flow of income. It links financial variables like savings rates and interest rates to real outcomes like output and employment. While simple, the identity provides powerful insight for understanding macroeconomic behavior and the impact of policies.