Saving and Investment

To understand the relationship between producing, consuming, saving and investment, it is useful to start with a simple story.

Imagine a Robinson Crusoe economy — just one person in it. RC’s consumption is limited to what he can produce by fishing, hunting and gathering. He allocates his time either laboring or enjoying leisure. If he consumes less than what he produced during a particular period, he can save that for later consumption.

For example, if he has saved some fish, he can forego fishing and instead use that time to fashion a spear for hunting. That means, his savings allowed him time to invest in creating that spear. He “converted” his saved fish into a spear. The spear is what is called “capital” — something that is not directly consumed but is used for producing goods for consumption (or even more capital.) His spear will increase his productivity in hunting, thus enlarging his consumption possibility.

Savings, invested properly, enlarge the “production possibilities” and therefor the consumption possibilities.

In a real economy, there are households and firms, and that allows exchange, something that’s not possible in the Robinson Crusoe economy. Households save, and through financial intermediaries, firms can borrow the savings to invest in increasing productive capacity, which increases the amount of stuff produced in the economy.

That in very  broad terms is the relationship between production, consumption, savings and investment. That  brings me to one of the questions Namami asked in the last “ask me anything”:

Is a healthy economy really strengthened by higher individual savings rates?

The answer is a conditional yes. For any economy to increase its production, savings are necessary but not sufficient. The savings have to be invested properly. If you save, and your savings are stolen by a robber or the government (hard to tell the difference in most cases) for their own consumption, the economy does not grow.

If someone recommends, “Don’t save. Go out and buy stuff”, that is analogous to telling RC to eat all the fish he catches, and therefore he foregoes making a spear, thus limiting his future production. Similarly if nobody saves in an economy, there will be no new investments, and the growth in production will stop.

I don’t know if Bhagwati did indeed advise people to save less. If he did, I am really surprised because he’s one of the brightest brains in economics. I am frankly puzzled.

4 thoughts on “Saving and Investment

  1. Very clear, thank you for the example with RC. My comment earlier was based on Gurumurthy relating Bhagwati’s take and critiquing it. I think I should read Bhagwati’s own statements first to see if he actually advises Indians to save less.

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  2. It’s a lot more complicated than this. Firstly, in the current period, more savings means less consumption, and so less spending, and so less income generated. This is Keynes’ paradox of thrift. More generally, the fallacy of composition – what is rational for an individual may not be rational in the aggregate. Robinson-Crusoe-type representative-agent micro-therefore-macro is not the right framework to think about this. Secondly, the dynamic story: an increase in the savings rate will only increase the level of per capita income, but not the growth rate of per capita income, because continuing to increase the capital stock will hit diminishing returns very quickly if the capital stock is already high, which is the case for rich countries. Rich countries can get richer by saving more, but not that much richer. This is the basic insight for which Solow won the Nobel Prize.

    India’s problem has traditionally been not that it saves too much or too little, but that it channels most of its household savings into gold and real estate rather than capital markets. A country cannot hope to grow if savings do not get channelized into capital expenditure. But that is beginning to change now. More and more Indians are investing in the stock market. This is a good sign……….

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