Everyday Terms in Macroeconomics – And Their Surprising Implications

Everyday Terms in Macroeconomics – And Their Surprising Implications

 

Macroeconomics is replete with regular-sounding terms such as consumption, savings and investments. However, if we were to interpret them from our everyday household experiences, we could be left with an erroneous understanding of the dynamics of the economy.

 

For instance, all else being equal, when a salaried household reduces consumption, it increases its savings without impacting its income. From an overall economy perspective, however, if we all reduced consumption of domestic goods and services, we would only reduce our total domestic income, with no impact on the stock of total savings.

 

Likewise, our household experience might tell us that savings are a pre-requisite to fund investments. From an overall economy perspective, however, households would struggle to increase the stock of collective savings by themselves. Instead, policymakers might be better advised to focus on investments and exports as a sustainable growth engine – higher savings would then automatically follow. 

 

Similarly, when a household puts money into a government savings scheme, it has less savings to fund other private sector investments. However, from an overall economy perspective, any government spending creates its own fresh savings. Government ‘crowding out’ of private investment can and does indeed occur, but via the market price of money, and not in a funding sense.

 
In this note, we will explore some of these questions and more. In Part A, we will start right at the beginning, with two basic macroeconomic identities. In Part B, we will consider some everyday economic transactions and their implications for the economy. In Part C, we will put all this together to debate possible implications for policymaking.

 

 

PART A: Basic Macroeconomic Identities

 

We begin with two basic macroeconomic identities. For a more rigorous read, do refer to any good textbook on macroeconomics (this note relies entirely on Dornbusch, Fischer & Startz). 

 

From a domestic output perspective, the Gross Domestic Product (GDP, denoted as ‘Y’) of an economy is given by the identity:

 

Y = C + I + G + (X – M)              …… (1)

 

Where 

 

C = Household consumption of goods and services (such as purchase of milk or a haircut)

 

I = Investment (such as a household buying a house, or a business buying new machinery or stocking up inventory)

 

G = Government spending (such as payment of government salaries, or purchase of defense equipment)

 

X = Exports, M = Imports, and (X – M) = net exports

 

Broadly, consumption ‘C’, investment ‘I’ and government spending ‘G’ together represent the total output consumed by the domestic economy. Removing imports leaves us with the portion of domestic consumption that was produced domestically. Adding exports – i.e., domestic output consumed elsewhere – would give us the total domestic output ‘Y’. 

 

Since the payment for this domestic output ‘Y’ would eventually reach the factors of production, adjusted for depreciation and indirect taxes, it would also represent the total national income. 

 

If we ignore depreciation, the total national disposable income (YD) would be Y, less net taxes and transfers (T) paid to the government. So,

 

YD = Y – T

 

From a deployment of earnings perspective, this disposable income would be channeled into either consumption (C) or savings (S). In other words,

 

YD = Y – T = C + S

 

Substituting for ‘Y’ from identity (1) gives us

 

C + I + G + (X – M) – T = C + S

 

Simplifying and rearranging terms, we get

 

S = I + (G - T) + (X - M)                                     …… (2)

 

Therefore, the total savings of the economy (S) is the sum of private investments (I), government deficit (G – T), and trade surplus (X – M). 

 

While students of economics would be very familiar with this identity, they would likely not have seen this represented in a form that suggests that ‘S’ is a dependent variable. We shall go into the reasons for this somewhat unusual depiction later in this note.

 

 

PART B: Individual Transactions – Impact on Economy

 

Economists view identities (1) and (2) in terms of goods and services produced over a period of time. Through the course of a quarter, for instance, they might consider how many haircuts and smartphones were purchased, how many houses and factories were built, and how much the government spent on roads and warplanes. Money would come into the picture only as a means to aggregate these disparate goods and services using a common unit of measure.

 

To dig deeper into the implications of identities (1) and (2), however, we will deviate from the usual approach in two respects.

 

First, instead of considering an aggregate set of connected activities over time, we will look at individual economic transactions, and judge their impact on the economy from identities (1) and (2). Admittedly, in the real world, economic transactions do not occur in isolation – they would each be influenced by, and would in turn influence, other economic transactions. However, since the economy itself is a combination of many such individual transactions, we posit that it is still very useful to consider each building block separately, with the caveat that we will have to avoid inferences that ignore these correlations.

 

Second, because we are considering individual transactions, we will consider the flow of ‘money’, as a store of value and as a medium of exchange. ‘Money’ – cash and bank deposits - forms a mobile part of the stock of savings (S), and exchange of money invariably accompanies economic transactions. 

 

1.    What Happens When We Purchase Domestic Goods & Services?

 

Consider that a consumer purchases a haircut from a neighborhood barber for Rs 300. With this rise in consumption ‘C’, from identity (1), GDP Y rises by Rs 300.

 

In paying for the haircut, the consumer’s stock of savings (money) would reduce by Rs 300, and in turn, the barber’s stock of savings would increase by Rs 300. 

 

If the barber pays no taxes, Rs 300 of savings has shifted from the consumer to the producer, and the total stock of savings in the economy stands unchanged.

 

However, if the barber does pay say Rs 30 of taxes on this transaction, then from identity (2), the stock of savings in the economy is reduced by this Rs 30. 

 

Some takeaways from this example:

 

1.1 Consumption of domestic goods and services is accompanied by savings shifting from the consumer to a domestic producer.

 

1.2 Consumption of domestic goods and services reduces the stock of domestic savings only to the extent of taxes.

 

As a corollary, what happens if the consumer skips the haircut, in order to save money and avoid paying the barber Rs 300? First, the increase in GDP is not registered. Second, there is no change to the total savings in the economy.

 

1.3 An economy cannot increase its total stock of savings by reducing consumption of domestic goods and services. 

 

2.    What Happens When We Purchase Imported Goods & Services?

 

Consider that a consumer purchases a foreign-made smartphone for Rs 50,000. 

 

From identity (1), household consumption ‘C’ goes up by Rs 50,000, and imports ‘M’ rises by Rs 50,000, and so GDP ‘Y’ and disposable income remain unchanged.

 

From identity (2), domestic savings ‘S’ declines by Rs 50,000, to the extent of the rise in imports ‘M’. This represents the money paid (or savings transferred) by the domestic consumer to the foreign producer.

 

Note that we have ignored indirect taxes in this example[1].

 

In summary:

 

2.1 Consumption of imported goods and services does not change total domestic disposable income; it causes a shift from domestic savings to consumption. 

 

2.2 Imported consumption results in savings shifting from a domestic consumer to a foreign producer.

 

3.    What Happens When We Export?

 

Consider that a foreign tourist pays foreign currency worth Rs 50,000 to settle a domestic hotel bill. 

 

From identity (1), exports ‘X’ increases by Rs 50,000, resulting in an increase in GDP ‘Y’ by Rs 50,000. 

 

From identity (2), the increase in ‘X’ results in an increase in savings ‘S’ by Rs 50,000, reflecting in the money received by the domestic hotel.

 

Note that we have again ignored any direct and indirect taxes in this example[2].

 

In summary:

 

3.1 Exports of goods and services increases domestic disposable income, all in the form of increased domestic savings. 

 

3.2 Exports shift savings from a foreign consumer to a domestic producer.

 

4.    What Happens When The Government Spends?

We have referred to taxes several times in the preceding sections. Let us now consider the impact of standalone government spending on the economy.

 

Consider that the government pays gross salary of Rs 25,000 into the bank account of a local civil servant, from which it deducts Rs 5,000 as income taxes.

 

From identity (1), from this transaction standalone, government spending ‘G’ increases by Rs 25,000, resulting in a higher GDP ‘Y’ of Rs 25,000. 

 

Disposable income ‘YD’ goes up by Rs 20,000, being the difference between increased ‘Y’ of Rs 25,000 and increased taxes ‘T’ of Rs 5,000. From identity (2), savings ‘S’ goes up by the same ‘G – T’ of Rs 20,000, in the form of net money credited into the account of the civil servant.

 

In summary:

 

4.1 Government domestic spending, net of taxes, increases domestic savings by a like amount. 

 

4.2 If all of taxes collected are spent by the government, any increased domestic consumption, inclusive of taxes, would not change the stock of domestic savings.

 

Note that government spending on imports – say on defense purchases – would not impact GDP[3].

 

5.    What Happens When a Household Invests?

Consider that a household uses accumulated savings (say bank deposits) to construct a house for Rs 10,00,000. This would deplete the money of the household by Rs 10,00,000 lakhs, as payments are made towards construction. 

 

From the household’s perspective, bank deposit savings have now been transformed into savings in the form of a house, valued at Rs 10,00,000. There is no net change to this household’s savings in the process.

 

From the perspective of those that built the house, the investment spending of Rs 10,00,000 resulted in money (savings) being paid to them against services rendered.

 

From identity (1), from the transaction, investments ‘I’ has increased by Rs 10,00,000, and so GDP ‘Y’ has increased by a like amount. From identity (2), the increase in investments ‘I’ translates into higher savings ‘S’ in the economy, in the form of money received by those that built the house. 

 

In summary:

 

5.1 Investments create fresh savings. 

 

5.2 Investments are also savings, in the eyes of those making the investment.

 

6.    What Happens When a Business Invests?

 

Consider a dairy farm that draws down its cash to pay cowhands Rs 10,000 to build up a milk inventory (note that business inventory is counted as investment). 

 

From the dairy’s perspective, Rs 10,000 of cash savings have been converted into milk inventory (investment) of Rs 10,000. This act of investment creation has resulted in cowhands earning savings (money) of Rs 10,000 for services rendered – in other words, the investment has created fresh net savings. 

 

In summary, from identity (1), GDP ‘Y’ increases by Rs 10,000 from the inventory investment. From identity (2), savings goes up by Rs 10,000 as well, in the form of money now with the cowhands. The dairy’s total savings remains unchanged, with cash savings now replaced by milk inventory savings.

 

This example underscores that the conclusions 5.1 and 5.2 are also applicable to business investments. 

 

Separately, it might be useful to trace what happens when the inventory is sold down by the dairy to consumers.[4]

 

7.    What Happens When Savers Lend to Consumers & Investors?

 

In the examples above, we had assumed that households and businesses had savings (money) available with them to initiate consumption and/ or investment. Implicitly, we have assumed then that the households and businesses had delivered goods and services in the past, and that the savings (money) they started with reflected the stored value of their past output. 

 

What if the household or business does not have this money to start with? They could take a loan from either someone who has savings to spare (from past output), or from a bank. 

 

Consider a household A that borrows Rs 10,00,000 from another household B that has savings (money) available. 

 

Ignoring transaction costs, from identities (1) and (2), A borrowing from B neither impacts GDP ‘Y’, nor the net stock of savings ‘S’, nor the money in the system.

 

B has transformed its savings from money into a loan to A. In turn, A now has a loan of Rs 10,00,000 from B (negative savings) and money Rs 10,00,000 (positive savings). Put together, A has no incremental net savings to start with.

 

If A now uses this Rs 10,00,000 to build a house, the steps described in section 5 (Household Investment) would repeat. Investments ‘I’, GDP ‘Y’ and savings ‘S’ would each go up by Rs 10,00,000. 

 

Instead, if A spends the funds on her son’s marriage, consumption ‘C’ and GDP ‘Y’ would go up by Rs 10,00,000, while total savings would remain unchanged. In effect, ‘A’ would now be left with net negative savings of Rs 10,00,000 (the loan from ‘B’), while those that provided the goods and services for the marriage would have positive savings for a like amount.

 

In summary:

 

7.1 Credit (loans) from savers to fund investments by borrowers results in an increase in investments ‘I’, GDP ‘Y’ and total savings ‘S’. The money component of savings, however, remains unchanged.

 

7.2 Credit (loans) from savers to fund consumption by borrowers results in an increase in consumption ‘C’ and GDP ‘Y’, while leaving total savings ‘S’ and the amount of money unchanged.

 

8.    What Happens When Banks Lend to Consumers and Investors?

 

Instead of a loan from another saver, consider the case where the household ‘A’ borrows Rs 10,00,000 from the Commercial Banking ecosystem (‘CB’). 

 

Specifically, on CB’s books, a loan asset of Rs 10,00,000 is registered against A. Against this, the account of A is credited with Rs 10,00,000. Note that we have defined balances in bank accounts as ‘money’ – to that extent, the act of CB providing a loan also creates fresh money. 

 

This creation of money differentiates lending by CB from lending by other savers.

 

As before, ignoring transaction costs, the act of CB giving a loan to A neither changes GDP ‘Y’ nor savings ‘S’. From A’s perspective, a negative savings of a Rs 10,00,000 loan from CB is matched by positive savings (money) in its banking account. 

 

Thereafter, the impact of A either investing the Rs 10,00,000 in a house, or pouring it into consumption, would have same impact as described in the previous section. 

 

In summary:

 

8.1 Credit (loans) from commercial banks to fund investments or consumption act the same way as loans from other savers, except that bank loans create net new money.

 

9.    How Does Government Borrowing & Spending Impact Money Creation?

In sections 7 and 8, we considered financing of private spending and investments by other savers and commercial banks respectively. Similarly, government deficits (G – T) can be funded either by borrowing from savers directly, or by borrowing from commercial banks, or through monetization by the central bank.

 

In all the routes, from identity (2), increased government deficits (G – T) would increase savings by a like amount. 

 

Similar to the reasoning in section 7, if the government deficits are funded by direct borrowing from savers, no net money creation accompanies the increase in savings. 

 

However, in line with the reasoning in section 8, if the government deficits are funded either by commercial banks or by the central bank, fresh money (bank deposits/ currency notes) are created to the same extent. 

 

In summary:

 

9.1 While government deficits funded by borrowing money directly from savers does not create net new money, deficits funded by borrowing from banks and central banks creates net new money.

 

 

PART C: Policy Implications

 

We now try and put all this together to address a few questions relevant for policymaking.

 

How Can We Increase Savings?

Prior to the Covid-19 pandemic, we often heard the lament that India was not saving enough. So how do we increase our savings?

 

From a household lens, we might think that savings is indeed directly in our control. After all, reducing consumption would increase household savings. But as we saw in 1.3, from an overall economy perspective, cutting back on consumption of domestic goods and services only reduces growth in GDP ‘Y’, while leaving the total stock of savings ‘S’ in the economy unchanged. 

 

Of course, from 3.3, cutting back on imported consumption ‘M’ would indeed help increase X – M, and hence increase savings. But this argument is a good example of the pitfalls of looking at individual transactions in isolation.

 

In an efficient economy, is it really possible to keep up consumption of domestic goods and services, while curbing imported consumption alone? We have seen net exports ‘X – M’ increase through the 2020 pandemic with a collapse in imports, but we have also seen a collapse in consumption of domestic goods and services, and hence GDP, alongside. More broadly, economists would argue that curbing imports ‘M’ through tariffs or other means can actually lead to inefficiencies and lower exports. 

 

Instead, here are healthier ways to increase overall savings. First, from 3.1, increased exports increase savings. Second, from 5.1, increased private investments increase savings. Finally, from 4.1, increased government deficits that go into purchase of domestic goods and services increase savings – as we are indeed seeing through the pandemic.

 

In short, from a policy perspective, it may be more accurate to think of savings ‘S’ as the dependent entity, and consider investments ‘I’, net exports ‘X – M’, and government deficits ‘G – T’ as the more controllable elements. This is why we have represented ‘S’ as the dependent entity in identity (2).

 

Does Government Spending ‘Crowd Out’ Private Investments?

 

This is another characterization that we often hear – that government spending ‘crowds out’ more efficient private investments.

 

Seen from a household sense, it conveys the impression that the stock of savings is limited, and the more that they are used up by the government, then less of it will be available to fund private investments. 

 

However, 4.1 tells us that government deficits that are channeled into spending on domestic goods and services create their own fresh savings. Government spending does not ‘crowd out’ savings in a literal, funding sense.

 

This does not mean that governments can expand fiscal deficits endlessly. Far from it. Increased government borrowings to fund its deficit could push up interest rates, reduce banking risk appetite, and hence disincentivize borrowings to fund investment. Likewise, excessive government spending and money creation can push up domestic inflation, and hence interest rates, and hence again disincentivize borrowing for investments. 

 

In short, government deficits do not physically constrict funds available to finance private investments. However, through the impact on inflation, interest rates and bank risk appetite, they can indeed disincentivize private investments. ‘Crowding out’ is real, but far more subtle and indirect than one might imagine.

 

Can the Government Reduce Inflation Risks While Increasing Deficits?

 

As noted previously, as a store of value and a medium of transaction, ‘money’ – both currency as well as bank deposits – forms a part of savings (S). Money is the most mobile form of savings, and its movement results in economic transactions such as consumption, investment and asset purchases.

 

From 8.1 and 9.1 above, commercial bank (and central bank) lending towards funding consumption, investment, and government spending creates net new money. If there is a demand slump and we wish to spur consumption and investment, we might want to increase the quantity of money in the system. On the other hand, if inflation is rising with too much money chasing too few goods, we might want to curb the amount of money in the system.

 

The current Indian context is paradoxical in many ways. With the ongoing slump in consumption and private investments, there is a need for the government to spend on infrastructure, education, healthcare, and nutrition, in order to spur jobs, output and productivity. At the same time, our quantity of money – across currency notes and bank deposits – is growing, and alongside, the CPI inflation trajectory is worryingly high. Some of this money is chasing risky assets and yields, and hence raising the possibility of asset bubbles and rising inequities.

 

In such a context, we might want to expand government spending and deficits, without increasing the quantity of money. From 9.1, government deficits that are funded by the government borrowing directly from savers – rather than from banks or the RBI – increase savings without increasing the quantity of money. As such, the issue of a ‘Corona Bond’ to directly tap funds from savers might be in order, rather than persisting with bank and RBI funding of our fiscal deficits.

 

Can Savings from Higher Net Exports Fund Government Expenditures?

 

This is a refrain that we often hear from economists these days. 

 

With the sharp drop in imports through the pandemic, our savings have risen with the rise in net exports X – M. Can these savings be tapped by the government to expand the fiscal deficit further?

 

Such arguments make little literal sense. Mathematically, from identity (2), higher net exports have to be balanced by higher savings. These incremental savings are not ‘available’ to fund anything else – they already fund the net export surplus. If the government was to now additionally borrow and spend, it would mathematically create fresh savings, and not ‘use’ any existing savings.

 

As a related analogy, this is akin to the creation of deposits on the liability side of banking books, to balance foreign currency assets arising from foreign currency inflows. It does not make sense to think of these deposits now being available to fund anything else – they already are funding the existing foreign currency banking assets, which in turn would be placed with and fund foreign entities.

 

At best, one could argue that rising availability of increased savings can bring down the cost of funds, and hence make it easier for government or the private sector to borrow afresh for spending, consumption and investment. Again, as with the ‘crowding out’ argument, the impact would be indirect and via markets, rather than from a literal funding sense. 

 

Further, the direction of impact is from certain – the creation of a surfeit of savings and money from higher net exports ‘X – M’ could well lead to inflation, and hence raise interest rates, rather than bring them down. 

 

Summary

 

We now summarize some of the perhaps counterintuitive conclusions. 

 

Increased consumption of domestic output does not reduce the stock of domestic savings (ignoring taxes). As a corollary, the economy cannot increase the stock domestic savings by reducing consumption of domestic goods and services – that would only reduce GDP growth, while leaving the stock of savings unchanged.

 

Government spending, private investments, and net exports all create fresh savings. It is a fallacy to think of total savings as a limited quantity, and as a pre-requisite for investments and government spending. Rather than lament low stock of savings, policymakers may be better served focusing on increasing productive investments and exports, while keeping inflation in check.

 

Government borrowing and spending does not directly crowd out private investments in a funding sense. However, because increased borrowings by the government can raise the overall cost of funds, through the impact on markets, they can and do impact the incentives for private sector to borrow and invest.

 

When consumption, investments or government spending is funded by banks (or central banks), the added savings is in the form of fresh money. As a mobile form of savings, fresh money can spur more economic activity and/ or inflation. On the other hand, when consumption, investments or government spending is funded directly by savers, no fresh money is created.

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[1] Indirect taxes such as customs duties would increase ‘C’ and ‘Y’ to that extent, leave disposable income ‘YD’ unchanged, while reducing savings ‘S’ by the extent of taxes.

[2] Any added indirect taxes paid by the tourist would increase exports ‘X’ and GDP ‘Y’ to that extent, leave disposable income ‘YD’ unchanged, while reducing savings ‘S’ by the same extent. Thereafter, any direct taxes paid by the hotel would further reduce savings.

[3] When the government imports, in identity (1), the rise in government spending ‘G’ would be matched by a rise in imports ‘M’. Likewise, from identity (2), there would be no change to domestic savings either. Of course, increased imports could impact the exchange rate and therefore impact other economic transactions. To reiterate, no economic transaction stands in isolation.

[4] Assume the dairy sells the milk for Rs 25,000. Fresh consumption ‘C’ of Rs 25,000 is then registered, alongside an inventory depletion of Rs 10,000. The consumers pay Rs 25,000 of savings (cash) as consideration to the dairy, which also sees a dip in its inventory (savings) of Rs 10,000. From identity (1), GDP ‘Y’ registers a net growth of Rs 15,000 (Rs 25,000 increase in ‘C’, less Rs 10,000 decrease in ‘I’). Disposable income increases by a like number. From identity (2), savings ‘S’ comes down by Rs 10,000, from the reduction in inventory (investment). Net across both legs of the transaction, consumption ‘C’ goes up by Rs 25,000, inventory investment ‘I’ is net unchanged, and so GDP ‘Y’ increases by Rs 25,000. The stock of savings remains net unchanged – having increased in the first leg with inventory creation and decreased in the second leg with inventory depletion.