Updated Jan 3, 2023 The words saving and investing are often used interchangeably. However, in an economic context, there is an essential distinction between the two. Therefore, in the following paragraphs, we will take a closer look at the difference between saving and investment and learn how the two terms are connected. Saving refers to the part of an individual’s income that is not consumed. Typically, this excess money is held in a bank account (i.e., savings account). However, it can also be kept in cash or used to buy government bonds or stocks. Although buying stocks and bonds is often referred to as investing in a financial context, it is important to note that it is still considered saving from an economist’s perspective. To illustrate this, meet Joanna. Joanna works as an engineer and earns 100,000 USD a year. She spends 60,000 USD of that money on consumption. This includes things like food, housing, clothing, vacation, and so on. In addition to that, she buys 10,000 USD worth of TSLA stocks, spends another 10,000 USD on Treasury bonds, and puts the remaining 20,000 USD in her savings account. Although the stocks and bonds are commonly referred to as investments (and rightfully so), Joanna adds 40,000 USD (i.e., 10,000 + 10,000 + 20,000) to her nation’s savings from a macroeconomic perspective. Investment describes a firm’s purchase of new capital. That means it refers to all purchases that raise the capital stock. This mainly includes capital goods, such as new production equipment, machinery, or buildings (see also factors of production). Because these purchases are restricted exclusively to capital goods, we can conclude that, in an economic context, all investment is made by producers and not consumers. To give an example, let’s look at an imaginary firm called EngineTech Inc., a producer of advanced electric motors. EngineTech plans to open a new factory close to Silicone Valley to meet the increasing demand caused by the growing popularity of electric vehicles. To do that, the company purchases a new factory building for 100M USD and new production equipment worth another 10M USD. As a result, the company adds a total of 110M USD (i.e., 100M + 10M) to its nation’s investment. Meanwhile, consumers don’t buy capital goods (because they don’t produce anything), so they don’t contribute to the nation’s investment. For the economy as a whole, saving should always equal investment (i.e., S = I). The reason for this is that banks use consumers’ savings to hand out loans. Most of these loans are handed out to firms that need to finance their investments. Therefore, more savings allow for more investment and vice versa. To illustrate this, consider a simple example. We know that Joanna has 20,000 USD in her bank account. For the sake of this example, we’ll assume that those are her only savings, and she’s the only person in the economy to save money. In that case, total saving is 20,000 USD. Her bank can now use Joanna’s money to hand out loans. That means, EngineTech Inc. (or any other company) can borrow that money to invest in new equipment. Hence, if Joanna only had 10,000 USD in her account, there would be less money available for investment, and vice versa. Although oversimplified, this example should give you a good idea as to why we can conclude that, in the economy as a whole, producers can invest as much as consumers save. Many people use the words saving and investing interchangeably. However, in an economic context, there is an important distinction between the two. Saving refers to the part of an individual’s income that is not consumed. By contrast, investment describes a firm’s purchase of new capital. For the economy as a whole, saving should always equal investment, because the availability of savings determines how much money is available for investment.Saving
Investment
Saving = Investment
Summary
Macroeconomics