3.18: The Saving/Investment Approach to Equilibrium

Another way to understand equilibrium in the economy is by looking at the relationship between savings and investment. When the total amount people save is exactly equal to the amount businesses plan to invest, the economy is in balance. At this point, all income that isn’t used for spending is being used by firms to support production.

Every person’s income is either spent or saved. At the same time, firms make plans to invest in their operations—whether it’s buying equipment, hiring workers, or expanding production. If the money saved by households is equal to the amount firms want to invest, then there’s no gap in the flow of income. What’s saved is being used, and the system keeps running smoothly.

For example, imagine Ane earns 600 dollars in a month. She spends 570 and saves 30. Across the economy, if businesses are planning to invest 30 dollars, then savings and investment are equal. That means no money is left sitting unused, and firms have enough to follow through with their investment plans. The economy remains steady.

But if Ane and others like her save more than what businesses want to invest, money builds up with nowhere to go. This could cause output to slow down. If the opposite happens—where investment is greater than savings—there may not be enough funds available to support all planned activity.

When savings match investment, the economy doesn’t need to adjust. This balance helps explain how production stays consistent when both sides of the income flow are working together.

Let’s begin with a closed economy with no government or foreign trade. In this two-sector model, macroeconomic equilibrium can be seen as a balanced seesaw, with savings on one side and investment on the other.

We begin with a basic identity in macroeconomics: total income, represented by Y, is the sum of consumption (C) and savings (S). This gives us:Y = C + S.

Simultaneously, equilibrium in the goods market is represented by Y = C + I, where I stands for planned investment.

Since both equations express total income, we can set them equal: C + S = C + I.

Subtracting consumption from both sides results in the condition S = I. This identity—savings equals investment—is the tipping point that determines whether the economic seesaw remains balanced.

Suppose Alex has a disposable income of five hundred dollars and spends four hundred seventy-five dollars. His savings would then be twenty-five dollars. If the level of planned investment in the economy is also twenty-five dollars, then savings equals investment.

Thus, the economy is in equilibrium, keeping the seesaw perfectly balanced.