Transcript

NARRATOR

The familiar circular flow diagram shows the flows of incomes, consumer expenditure, saving and investment. Suppose households decide to save more and, therefore, to consume less. How can it be that investment automatically increases to compensate?

As households spend less in the shops, firms will find that their stocks of unsold consumer goods will build up. This counts in the national income accounts as additional investment, although it is unplanned. The identity – saving equals investment – still holds but only because of the way in which the terms 'saving' and 'investment' are defined for accounting purposes.

Now for the opposite story. Suppose households decide to save less and, therefore, to consume more. One possible outcome is that firms will run down stocks to satisfy the extra demand. This counts as unplanned disinvestment, so the lower saving is accommodated by reduced investment.

But suppose firms have no spare stocks to run down. How can saving still equal investment? Think about this before continuing with the tutorial. [PAUSE] The answer is that if firms have no spare stocks, households' plans to save less and consume more will be frustrated since there is no more available to buy. Part of their saving will now be unplanned, but neither total saving nor total investment will change.

The national income identities you studied in Block 1 belong to the world of the accountant in which every change in a variable is compensated by a corresponding change in another, so that the accounts always balance. The national accounts record the values of actual expenditure and actual output. So an increase in stocks – called inventories in the national accounts – even if unplanned, is recorded as investment. And unplanned saving by households is reflected in the recorded level of consumption.

But none of this means that planned expenditure will always equal output or that planned saving will always equal planned investment. And if plans don't accord, then, as we have seen, someone's plan will be thwarted. We consider now what happens to national income when plans do not accord. We will start by reinterpreting the circular flow diagram.

The diagram is familiar but, now, the labels are going to mean something rather different. Consumer expenditure now means planned consumer expenditure. This is how much households would like to spend given the income that they have. So saving now means how much they would like to save – planned saving. And investment now means how much firms would like to invest – planned investment.

Let's start off with these plans in harmony so nothing is rocking the boat. But now, suppose that households spontaneously decide to consume more. The flow of consumption expenditure becomes stronger as they save less. But this doesn't mean firms simultaneously plan to invest less. So there is a surge of expenditure, and the boat does rock.

The balance of the economy has been upset, or to put it another way, the equilibrium has been disturbed. Recall that, in equilibrium, there is no impetus within the model for any economic agents to change their behaviour. Households are not coming under pressure from changed incomes to change their consumption or saving plans. And firms are not coming under pressure from changed demand to change their production plans.

Following the spontaneous surge of consumer spending, however, there is an impetus for firms to change their behaviour by producing more to satisfy the extra demand. Equilibrium is quite different from identity. Actual saving and actual investment will still be identical when households increase their spending, as stocks will be run down, but the equilibrium equality between planned saving and planned investment will no longer hold true.

If firms do not wish to see their stocks depleted for long, they will need to increase production. According to Keynes's theory, this imbalance will put in train a process that will lead to a restoration of equilibrium. National income will increase as firms respond to the extra consumption demand by producing more, and therefore, paying out more in incomes. And equilibrium will be restored at a higher level of income when the additional income earned is sufficient to increase planned saving to its previous level.