Investment in the circular flow of money

  • #1
In some (closed) models of the circular flow of money Investment is shown as a demand from firms on capital goods and services. In other models it is shown as a flow from the financial sector to the firms.

It seems to me that these two things are clearly different. The first case is genuine capital investment but the second is really corporate borrowing. There is no necessary equality between the two.

For example a firm could invest some of its revenue in capital investment without borrowing. Equivalently a firm could (dangerously) borrow money to pay off its wage bill until the goods market picks up again.

The most that you could say would be :

Factor Payments + Capital Investments = Sales Revenue + Corporate Borrowing

The financial market (at most) would ensure that :

Savings = Corporate Borrowing

But the claim that :

Savings = Capital Investments

...seems fallacious?

Am I missing something? What additional assumptions are required?
 

Answers and Replies

  • #2
talk2glenn
Economics is not accounting. For its purposes, savings equals investment. A firm cannot invest revenue or borrow principal. It may help to think of a form that retains earnings as borrowing from its capital investors, eg shareholders.
 
  • #3
Thanks for your reply. I just want to make sure my understanding is 100% correct though.

Take the simplest possible circular flow economy.

1) Closed economy
2) No government
3) No capital investment in machines by firms

P - output, C - consumption, I - investment, S - savings, Y - income, t - time (years)

For firms : stock(t+1) = stock(t) + P - C
For households : wealth(t+1) = wealth(t) + Y - C

Now say some stock is unsold, then it is counted as Investment by the firm in inventory.

So for firms : stock(t+1) - stock(t) = I => P = C + I

Similarly, any increase in the wealth of households is treated as Savings

So for households : wealth(t+1) - wealth(t) = S => Y = C + S

Now, since firms are 100% owned by households, the firms do not 'own' any of the profits, products or factor incomes. Everything generated is therefore 'income' to the households. Crucially, though, not all of this income is actually 'paid' to the households within the year in question. Indeed some of it may well be quite illiquid and locked up in firms on a long term basis for many years, (in this case as unsold goods inventory).

Therefore since households own all output, it is due to them as income in one form or another => Y = P

So combining the above we get : C + S = C + I => S = I
 
  • #4
talk2glenn
You have the right idea, but you can look at it even more simply.

Investment is defined as deferred consumption. As in, households face two choices when allocating their annual production: they can eat it, or they can save it. Abstract away from the concept of money, capital, wealth, and such. Imagine this is a medieval economy and the only output is grain. If households produce 1000 bushels, but only consume 900, then we'd say without controversy that they've saved 100.

But what happens to those bushels? They enter the countries invetory stocks, to be eaten later (perhaps next year, when the harvest is a poor 800 bushels). These inventory stocks, then, are made a component of Investment. The households don't have any other options. They can up and burn the grain, but then it's counted as consumption (kindling?). They can lock it away in some barn somewhere and forget it exists, but then it counts as Investment, or they can feed it to livestock, used in the production of some dairy next year, but thats Investment too. Even if they bury it in the yard and forget about it while it rots, it'd just be called Investment minus Depreciation. There's no requirement in the definition that Investment be wise or productive; this is Adam Smith's "unintended consequences" parable.

The identities are constructed in such a way that, by definition, Output = Consumption + Savings = Production + Investment.
 
  • #5
Thanks Glen, thats great. It is much clearer now. Getting rid of money is a nice way to look at it.

Last thing though .

Output = Consumption + Savings = Production + Investment
Can you clarify what the difference between Output and Production is though? To me it seems more like consumption
 
  • #6
talk2glenn
Where production is defined as the sum of all final goods and services for the benefit of the consumers, and investment is defined as the sum of all final good and services for the benefit of the producers.

Not very fair, I grant you, given that both categories are "produced" - capital goods and consumer goods is better terminology.
 
  • #7
Thanks Glen. On the surface of it these identities seem so (deceptively) simple, but the key to real understanding isnt the formulae it is the definition of the terms.

Now if I consider a simple extension to your medieval farm example. Lets say we have a king who demands a 5% tax on all production. The king only takes from the economy, it is pure leakage.

Now, if households have 100 bushels left after consumption, and they pay 50 to the king they have 50 left as savings.

income = C + S + T 1000 = 900 + 50 + 50

Now on the expenditure side, is this tax included in investment or production?

I suppose it depends what the king does with it, does he consume it over the year or does he stockpile it? Is that the right way to look at it? or is I = 100 regardless of what the king does with it?

I was thinking of government as being 'outside' the economy before but im now thinking it really should be considered as simply a 'special type' of household that receives income T and consumes G.
 
  • #8
talk2glenn
Le's keep things simple and assume there isn't any elasticity in our hypothetical economy, and they always save 100 units of grain, no matter what. On the income side, the King's tax would reduce household income by 5%, and increase public income by the same. On the expenditure side, the households would consume 5% less grain, with the balance going to the crown. In our medieval economy, then, the grain tax wouldn't affect investment or output; GDP remains the same, and we just observe some shifting among the constituent parts.

In the real world, of course, the government doesn't always spend everything it taxes - some governments operate at a surplus (revenues exceed expenditures), and others at a deficit. The net balance between public taxes and expenditures is added to investment (just as net household surplus is, by definition, investment). So, government deficits reduce investment, and surpluses increase it. I'm sure you've heard about the "crowding out" in political discussion of deficits; this is it. Again this assumes no substitution between savings and investment for simplicity.

Fundamentally, the addition of a government agent doesn't change the calculus - we can imagine the state as just another consumer of final goods (albeit a very large one).
 
  • #9
Cheers glen you are a star... understood... :eek:)
 

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