I have had occasion to make many references in the past to Richard Lipsey’s wonderful article “The Foundations of the Theory of National Income” which was included in the volume Essays in Honour of Lord Robbins. When some 40 years ago, while a grad student at UCLA, I luckily came upon Lipsey’s essay, it was a revelation to me, because it contradicted what I had been taught as an undergrad about the distinctions between planned (ex ante) investment and savings, and realized (ex post) investment and savings. Supposedly, planned investment and planned savings are equal only in equilibrium, but realized investment and savings are always equal. Lipsey explained why the ex ante/ex post distinction is both incorrect and misleading. In this post I want to begin to summarize some of the important points that Lipsey made in his essay.
Lipsey starts with a list of seven erroneous propositions commonly found in introductory and intermediate textbooks. Here they are (copied almost verbatim), grouped under three headings:
I The Static Model in Equilibrium
1 The equilibrium of the basic Keynesian model is given by the intersection of the aggregate demand (i.e., expenditure) function and the 45-degree line representing the accounting identity E ≡ Y.
II The Static Model in Disequilibrium
2 Although people may try to save different amounts from what people try to invest, savings can’t be different from investment; realized (ex post) savings necessarily always equals realized (ex post) investment.
3 Out of equilibrium, planned savings do not equal planned investment, so it follows from (2) that someone’s plans are being disappointed, and there must be either unplanned savings or dissavings, or unplanned investment or disinvestment
4 The simultaneous fulfilment of the plans of savers and investors occurs only when income is at its equilibrium level just as the plans of buyers and sellers can be simultaneously fulfilled only at the equilibrium price.
III The Dynamic Behavior of the Model
5 Whenever savers (households) plan to save an amount different from what investors (business firms) plan to invest, a mechanism operates to ensure that realized savings remain equal to realized investment, despite the attempts of savers and investors to make it otherwise. Indeed, this mechanism is what causes dynamic change in the circular flow of income and expenditure.
6 Since the real world, unlike the simple textbook model, contains a very complex set of interactions, it is not easy to see how savings stay equal to investment even in the worst disequilibrium and the most rapid change.
7 The dynamic behavior of the Keynesian circular flow model in which disequilibrium implies unintended investment or disinvestment can be shown by moving upwards or downwards along the gap between the expenditure function and the 45-degree line in the basic Keynesian model.
Although some or all of these propositions are found in most standard textbook treatments of national income theory, every one of them is wrong.
Let’s look at proposition 1. It says that the equilibrium level of income and expenditure is determined algebraically by the following two relations: the expenditure (or aggregate demand) function:
E = E(Y) + A
and the expenditure-income accounting identity
E ≡ Y.
An accounting identity provides no independent information about the real world, because there is no possible state of the world in which the accounting identity does not hold. It therefore adds no new information not contained in the expenditure function. So the equilibrium level of income and expenditure must be determined on the basis of only the expenditure function. But if the expenditure function remains as is, it cannot be solved, because there are two unknowns and only one equation. To solve the equation we have to make a substitution based on the accounting identity E ≡ Y. Using that substitution, we can rewrite the expenditure function this way.
E = E(E) + A
If the expenditure function is linear, we can write it as follows:
E = bE + A,
which leads to the following solution:
E = A/(1 – b).
That solution tells us that expenditure is a particular number, but it is not a functional relationship between two variables representing a theory, however naïve, of household behavior; it simply asserts that E takes on a particular value.
Thus treating the equality of investment and savings as an identity turns the simply Keynesian theory into a nonsense theory.
The point could be restated slightly differently. If we treat the equality of investment and savings as an identity, then if we follow the usual convention and label the vertical axis as E, it is a matter of indifference whether we label the horizontal axis Y or E, because Y and E are not distinct, they are identical. However we choose to label the horizontal axis, the solution of the model must occur along the 45-degree line representing either E = Y or E = E, which are equivalent. Because, the equality between E and itself or between E and Y is necessarily satisfied at any value of E, we can arbitrarily choose whatever value of E we want, and we will have a solution.
So the only reasonable way to interpret the equality between investment and saving, so that you can derive a solution to the simple Keynesian model is to treat E and Y as distinct variables that may differ, but will always be equal when the economy is in equilibrium.
So the only coherent theory of income is
E = E(Y) + A
and, an equilibrium condition
E = Y.
E and Y do not represent the same thing, so it makes sense to state a theory of how E varies in relation to Y, and to find a solution to the model corresponding to an equilibrium in which E and Y are equal, though they are distinct and not necessarily equal.
But the limitation of this model is that it provides us with no information about how the model behaves when it is not in equilibrium, not being in equilibrium meaning that E and Y are not the equal. Note, however, that if we restrict ourselves to the model in equilibrium, it is legitimate to write E ≡ Y, because the equality of E and Y is what defines equilibrium. But all the erroneous statements 2 through 7 listed above all refer to how the model.
The nonsensical implications of constructing a model of income in which expenditure is treated as a function of income while income and expenditure are defined to be identical has led to the widespread adoption of a distinction between planned (ex ante) investment and savings and realized (ex post) investment and savings. Using the ex ante/ex post distinction, textbooks usually say that in equilibrium planned investment equals planned savings, while in disequilibrium not all investment and savings plans are realized. The reasoning being that is that if planned saving exceeds planned investment, the necessity for realized savings to equal realized investment requires that there be unintended investment or unintended dissaving. In other words, the definitional identity between expenditure and income is being used to tell us whether investment plans are being executed as planned or being frustrated in the real world.
Question: How is it possible that an identity true by definition in all states of the world can have any empirical implications?
Answer: It’s not.
In my next installment in this series, I will go through Lipsey’s example showing how planned and realized saving can indeed exceed planned and realized investment over the disequilibrium adjustment induced by a reduction in planned investment relative to a pre-existing equilibrium.
UPDATE (2/21/2015]: In the second sentence of the paragraph beginning with the words “An accounting Identity provides,” I wrote: “It therefore adds information not contained in the expenditure function,” which, of course, is the exact opposite of what I meant to say. I should have written: “It therefore adds NO NEW information not contained in the expenditure function.” I have now inserted those two words into the text. Thanks to Richard Lipsey for catching that unfortunate mistake.