Why does investment spending not equal saving in the circular flow?

1 Answer

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

There are a number of reasons why savings will not equal investments in the circular flow model.  Let us look at some of them.

First, the model counts savings somewhat differently than we might think.  Anything that a household makes in income and does not spend on consumer goods is seen as savings.  This could include money that the households spend on paying down debt.  That money is “saved” but not invested.

Second, the model defines investment somewhat differently than we might think.  In everyday language, we would say that buying stocks is a form of investing.  But the model does not count buying stocks.  Investment only consists of activities that increase the amount of capital goods that exist.  Buying stocks does not do this.  The money spent on stocks is saved by not invested.

Finally, there are things that businesses do that are defined as investing but which do not draw on people’s savings.  For example, if a business buys a large new machine, it is investing.  However, it might have paid for that machine at least in part with money that it got in exchange for goods and services.  In other words, it is taking money that was not saved and is investing that money.

For these reasons, savings and investments are not necessarily equal in a circular flow model.