The neo-classical explanation of business cycles in terms of a discrepancy between savings and investment was rejected by Keynes in his General Theory.
Keynes propounded a new theory to the effect that savings and investment are always and necessarily equal.
The identity of savings and investment holds valid at any level of income and regardless of the fact that decisions to save and decisions to invest are made by different people for different reasons.
Image Source: gateinvestmentgroup.files.wordpress.com
ADVERTISEMENTS:
This identity of savings and investment is implicit in the fact that total income and total expenditure are only two names for the same thing.
Since investment is the name given to monetary outlays on things other than consumption, it is nothing but income minus consumption or I=Y—C.
But this quantity is exactly what we understand savings to be or S=Y—C. If both savings and investment are equal to income minus consumption, we get the identity of savings and investment as a matter of logical necessity. This is one sense in which Keynes talks about the savings-investment relation, the other being the schedule sense.
ADVERTISEMENTS:
The truism may be written as follows:
This conclusion seems to be a little puzzling since there is obviously no mechanism whereby any individual’s decision to save causes somebody to invest an exactly equal amount. But this riddle will be solved as soon as we remember that this proposition applies to aggregate saving and investment.
It is perfectly possible for any individual to save more without investing more himself. Neither is it necessary that aggregate investment should increase whenever any individual decides to save more.
This would be so if the increase in an individual’s saving left unchanged the amount saved by all other individuals together, so that it always meant an increase in aggregate saving.
ADVERTISEMENTS:
But we cannot assume that, since the individual must decrease his expenditure on consumption goods to the extent that he increases his savings. This diminution in consumption diminishes Y and therefore leaves Y—C or S the same as before.
The classical view that an individual, in deciding to save more, increases the aggregate amount of saving was based on an essentially short-sighted view.
The decision of an individual to save a given amount out of his income is not likely to have any appreciable effect on his income.
But if we take the economy as a whole and neglect the effect of changes in expenditures on total incomes, we are making the contradictory assumptions (a) that when people save more they spend less on consumption goods and (b) that the people who sell consumption goods do not receive any less money.
Thus the decisions of income-receivers as between saving and spending do not affect the aggregate volume of saving but do determine the size of both income and consumption. Although there is no mechanism whereby decision to save brings about an equal value of investment, there is a mechanism whereby decisions to invest bring about an equal amount of saving.
The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus the act of investment in itself cannot help causing the saving to increase by an equal amount.
The main purpose of Keynes in propounding the savings investment theory was to emphasise the dominant role of investment in the functioning of the capitalistic economy. It is investment which sets the pace for the economy as a whole and investment depends on the marginal efficiency of capital.
It is not necessary to bother about savings, since savings are involuntary in character and have got to accommodate themselves to the volume of investment. Classical economists also held that savings and investment are equal, but that this equality is brought about by the rate of interest.
In the Keynesian system, the rate of interest has no part to play in making savings equal to investment.
Neo-classical economists have differed from the classical position and found the main cause of cyclical fluctuation in disequilibrium between saving and investment. Booms and depressions were held to be caused by the excess of investment over savings and the excess of savings over investment respectively.
As a corollary to this line of thought, Wick sell conceived of a natural rate of interest which by making savings equal to investment would maintain the economy at its equilibrium level.
According to the new analysis, not only the possibility of discrepancy between savings and investment is denied, but the virtues of the concept of equilibrium as such are also denied. Equilibrium can be at under-employment level. No useful purpose is served by the capacity to maintain the condition of equilibrium.