I was planning to write another installment in my series of posts on the savings-investment identity in which I have been working through and summarizing Richard Lipsey’s essay “The Foundations of the Theory of National Income.” Perhaps I will get to my next installment later this week. If not, then I hope to do so early next week. But it occurred to me that the best way to explain why saving is not identical to investment is by framing the discussion in terms of the familiar circular-flow schematic model of income and expenditure. The accompanying diagram is a typical representation of the circular-flow model, with a government sector (government spending and taxes) and a foreign sector (exports and imports) included in addition to just investment and saving.
As indicated by the arrows in the diagram, investment, government spending, and exports are added to the circular flow while savings, taxes and imports are withdrawn from the circular. In the conventional terminology, investment, government spending and exports are injections, and savings, taxes and imports are leakages. And, of course, a basic property of the model is that injections and leakages are equal. It is only in the simplest model, with no government and with no foreign sector, so that there is just one injection (investment) and one leakage (saving), in which the familiar equality between investment and savings holds.
So the question that I want to ask now is simply this: is the equality in the simple one-sector model between injections (investment) and leakages (savings) an equality that may or may not be true, or is it an identity that must necessarily be satisfied in all places and at all times?
Well, rather than try to argue this through in terms of abstract economic or accounting reasoning, let’s think about it in terms of a simple physical analogy, one that we could actually demonstrate for ourselves in our own homes. So think of a bathtub with some water in it. Depending on the size of the bathtub and the amount of water in the bathtub, the water will reach some uniform height in the bathtub. Let’s call that uniform water level an equilibrium. It’s an equilibrium, because if that’s all the water there is in the bathtub, and we don’t let any water out of the bathtub, and, for purposes of our little thought experiment, we ignore any evaporation, that water level will persist indefinitely, with no tendency to change. No water in, no water out, and you have a constant water level. In other words, with no injections and no leakages, the water level of the bathtub is stable; it does not change. The water level is in equilibrium.
But if you turn on the faucet and water starts to flow into the bathtub, the water level will start to rise. As long as water is being injected into the bathtub, the water level will keep rising, and the water level will not be in equilibrium. However, if you unplug the drain to the bathtub, water will start flowing out of the bathtub. What happens to the water level? That depends on whether water is leaking out of the bathtub through the drain faster than water is being injected into the bath tub through the faucet. If injections are greater than leakages, the water level will rise, and if leakages are greater than injections, the water level will fall. And if, by chance or design, injections are exactly equal to leakages, then the water level will be stable and back in equilibrium. Thus, the condition for a stable water level is that injections be exactly equal to leakages. When injections into, and leakages from, the bathtub are equal, the water level of the bathtub is in equilibrium. When injections are greater than leakages, the water level rises, and when leakages are greater than injections the water level falls.
I think all that is pretty elementary, and I am guessing that if you look in any textbook treatment of injections and leakages in the circular flow of income, you will find a similar story about the effect of a difference between injections and leakages on the level of income. (Check out the Wikipedia article on the circular flow of income, especially the section on equilibrium.)
So, if you believe that investment and savings are identically equal, please tell me whether you also believe that injections and leakages are identically equal. And if you do believe that injections and leakages are identically equal, please explain to me what the difference is between the circular-flow-of-income model with injections and leakages identically equal in equilibrium or out of equilibrium and the bathtub model in which the water level can change only insofar as injections and leakages are not equal.