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So, I've had this confusion for a long time. We all know how spending is absolutely vital for economic growth. However, at the same time, are savings necessary too?

My initial opinion was "no". In a very particular argument, someone argued with me that "since the money that goes into the companies as investment is nothing but the savings money,savings are important too"

I feel that if companies are getting all they want from direct profits (consumer spending), say with 100% consumer spending, they wouldn't need investments.

Would I be right in my argument? Or am I wrong?

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  • $\begingroup$ You are wrong. Like....totally wrong :-D Think of it without companies and savings and so on which complicate the analysis. Suppose you can eat a peanut or plant it in order to grow a tree which gives you more peanuts in the coming year and thereafter. Obviously, if you save the peanut, your growth would be higher. Now go say sorry to that someone from that particular argument... $\endgroup$
    – HRSE
    Nov 25, 2015 at 7:17
  • $\begingroup$ What I'm saving is that if we can deviate from the point where "Savings" = Investments" into a point which something like "Consumption" = "Profit" = "Further Investment" $\endgroup$
    – WorldGov
    Nov 25, 2015 at 9:55
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    $\begingroup$ you need to think about it in real terms, not in terms of money flows, then it will be much more obvious. you can only eat the peanut or plant it. if you eat=consume it, you cannot plant=save it. $\endgroup$
    – HRSE
    Nov 25, 2015 at 11:52
  • $\begingroup$ @HRSE It's not clear that planting a plant corresponds to saving money. Your comment reads more like an analogy, in which case it doesn't explain anything $\endgroup$
    – user253751
    Feb 22, 2021 at 18:12
  • $\begingroup$ Indeed, a full answer would require establishing that 1) investments are necessary for growth and then 2) that total net savings (including the profits withheld by firms) equal investments $\endgroup$
    – HRSE
    Mar 4, 2021 at 15:19

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I don't know if you're arguing a theoretical framework or whether saving is important for real economic growth. In theory a special case where all consumers would spend 100 % (MPC=1) of their income is possible to argue - the framework would be loaded with questions - it might, for example, make banks redundant.

In basic economic models savings is often considered equal to investment (you see a variation of S=I in many macroeconomic models) which means that all saved income is used for investment and therefore expected to expand the economy for future periods. In real life the relationship isn't quite this straightforward, but the basic idea still holds.

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  • $\begingroup$ I'm arguing this on a theoretical point of view. In conventional economic models, like you said, "Savings" = "Investments" What my point of view is that whether this equation would hold "Consumption" = "More profits" = "More Investment". My argument is that savings are necessarily a deviation from consumption. And the money spent due to consumptions goes into - well - companies. So does investment. Sorry if I'm not making sense! $\endgroup$
    – WorldGov
    Nov 25, 2015 at 9:56
  • $\begingroup$ Don't worry, I understand your point. It is a valid special case and there is no inherent difficulty with everything being consumed. Although if you're arguing that consuming everything will lead to more economic growth, you're most likely wrong as you'd eliminate all investment from individual consumers as well as the banking sector (at least the consumer side) and economic growth with basic models would be 0. You might get around this by defining a new equation for investment (based on monetary consumption) and defining on how investment flows work with the banking sector becoming obsolete. $\endgroup$
    – John L.
    Nov 25, 2015 at 12:36
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Your intuition is correct. With 0 savings there could be not only no economic growth but no economic activity assuming depreciation exists.

According to the Harrod-Domar model the growth rate of capital per worker is equal to:

Growth Rate (g) = Savings Rate (s) / Capital-Output Ratio (k)

Clearly under this model if the savings rate was 0 the growth rate of capital per worker would be 0.

This is because it is assumed that the production function has essentially only two inputs. Labor, and capital. The generic production model that is used with the Cobbs-Douglas model is

Total Output (Y) = f(K,L) = (K^a)(L^(1-a)), where 0 < a < 1.

K = the total amount of capital in a country

L = total amount of labor in a country.

a in this equation is the emphasis that is placed on either labor or capital.

Assuming that this function generically holds if K is equal to 0 that would mean that regardless as to the level of capital total output would equal 0.

So, because the growth rate of capital per worker is 0 at a 0 savings rate this means that K is a constant and unchanging.

This is where depreciation comes in. Assuming that capital goods depreciate over time the capital stock K will over time be getting smaller. Machines break, etc. In the long run capital stock will shrink to 0 meaning there will no longer be any economic activity at all.

In essence because savings goes to investment which creates capital, without any level of investment we would eventually run out capital as it depreciates leading to an output of 0.

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  • $\begingroup$ Notice that to have sustained growth (which Harrod-Domar or Solow do not show), you would need a constant increase in savings. THis is not how economies behave. So, clearly savings are not enough for economic growth. $\endgroup$
    – luchonacho
    Apr 26, 2017 at 19:38
  • $\begingroup$ I'm confused as to what you're saying. The question is asking what would happen if you have a savings rate of 0. I assume this is a constant savings rate. This isn't a practical question given that the savings rate will never be 0 permanently. $\endgroup$
    – TheSaint321
    Apr 26, 2017 at 19:39
  • $\begingroup$ Furthermore what are you talking about saying that Harrod-Domar or Solow don't show sustained growth? That's the whole point of the model. To find a sustainable growth rate in the steady state. $\endgroup$
    – TheSaint321
    Apr 26, 2017 at 19:40
  • $\begingroup$ Mine was a comment, not arguing against your post (which I upvoted). The standard Solow model does not have sustained growth. The steady state is, as the name states, steady. The only way to introduce sustained economic growth is by introducing a mechanism for change in $A$. $\endgroup$
    – luchonacho
    Apr 26, 2017 at 19:54
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    $\begingroup$ Yeah you're technically right. The Solow model only allows for sustained growth assuming growth in population and technology in the steady state. That's what I was referring to. But you're correct if there is no technological growth or population growth then in the steady state K would be constant. $\endgroup$
    – TheSaint321
    Apr 26, 2017 at 19:56
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Investment is necessary for economic growth.

And in theory, most, if not all investment comes out of savings, at least in a closed economy. To that extent, savings are necessary for economic growth.

Now I could make up a case where all the savings came from borrowed money, probably from abroad, with all investment earning enough to repay the loans and still support growth. But that would be an outlier case.

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I believe that you are somewhat right (in the short run). S=I is a national accounting identity in the closed classical model, but is it valid in real life? The general consensus is no. You are right in thinking that a firm could simply use profits to invest (for a real life example look at Starbucks). However, if there was no savings, long run growth will be slow (if there is any at all). There are a couple reasons for this:

1) Monetary Expansion: When money is put into a bank (saved) it creates loans for businesses, and the money expands (by the money multiplier). A dollar saved can create loans for multiple firms, which increases investment by more than a dollar, whereas a dollar consumed only funds investment (maybe) for one firm. For this reason, a dollar saved tends to have more of an impact on investment than a dollar consumed.

2) No lending: If someone goes through their life consuming every dollar earned, then when they cannot work anymore, they will be in trouble. If they do not save, they must then borrow. This creates a huge problem, because from whom will they borrow? NOBODY SAVES. If there is some sort of government safety net like social security, then the government must pay these people. But since nobody saves (aka nobody buys government bonds), the government must always have a balanced budget, so government spending must decrease (since transfer payments are not included in government spending) in order to pay out social security. This leads to slowed (or even negative) growth. Therefore, if the government wants to maintain spending and growth, they cannot offer these social safety nets. Since the consumer cannot borrow from the government, and they cannot borrow in the private market, they can't consume.

These are two reasons why savings is pivotal for growth. I hope this answer clears things up for you.

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  • $\begingroup$ Can you please back up your claim that the "general consensus" is that S is not equal to I? Give some references maybe? In any case, I think this is wrong. S=I by definition, even in an open economy. External savings make up for any difference between national savings and investment. $\endgroup$
    – luchonacho
    Apr 27, 2017 at 8:52
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The basic textbook model of economic growth is the Solow growth model. According to this model, economic growth on a per capita basis comes about due to (i) technological progress, and (ii) increasing the quantity of capital per inhabitant. Savings are important for increasing the quantity of capital per inhabitant. So yes, savings are important.

How important? Well there is some discussion about that in the literature. It's not as important as technological progress it seems.

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  • $\begingroup$ In the Solow model a savings rate of 0 would imply an eventual output of 0, so this seems false. $\endgroup$
    – Giskard
    Apr 25, 2017 at 11:54
  • $\begingroup$ 1. Whether it's true or false is neither here nor there. The question is whether the model provides a good enough description of reality within its domain of application; 2. The Solow growth model is not limited to a particular production function; 3. It might very well be the case that an economy where there exists no savings that output is indeed zero. This is an empirical question. Not a theoretical one. $\endgroup$
    – Toby
    Apr 25, 2017 at 12:41
  • $\begingroup$ Let me clarifiy: The statement "It's not as important as technological progress it seems." is not backed up by anything in your answer. You refer to the Solow model, where savings are clearly necessary and changing the savings rate impacts output. So your general claim is false. (Alternative-true.) $\endgroup$
    – Giskard
    Apr 25, 2017 at 12:47
  • $\begingroup$ If you noticed, then I referred to the literature. Since the relative importance of technological progress and per capita capital accumulation was not part of OP's question, I give no specific references. And savings in the Solow model are not "clearly necessary". This depends on the choice of production function. $\endgroup$
    – Toby
    Apr 25, 2017 at 12:55
  • $\begingroup$ I still disagree with your answer, but I like your comment that the necessity of savings depends on the exact choice of production function. $\endgroup$
    – Giskard
    Apr 25, 2017 at 19:48

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