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  • Heather Luea

    By Heather Luea, Academic Department Chair 
    Published September 2014

    One of the most frequent questions from students is whether savings or spending drive the economy. The simple answer is: both! The actual answer is much more complicated. Too much savings can depress economic activity in the short run but drive economic growth in the long run. Too much spending accelerates the economy in the short run but can lead to inflation and slower economic growth in the long run. Let’s take a closer look.

     

    Borrowers and savers meet in the loanable funds market. Borrowers can include households, corporations, and even the government. Savers include anyone or any entity, including foreign governments, who want to invest in a savings instrument. For example, if an investor purchases a corporate bond, that investor is a saver and the company is a borrower in the loanable funds market. The company may use those bond funds to finance an expansion or purchase capital equipment. When the company makes these purchases, gross domestic product (GDP) increases. These transactions translate into economic activity, which drives the economy in the short run. In addition, because these funds were used to make capital investments or investments in the resources used to produce goods and services, long-run economic growth is also impacted. Borrowing these funds would not have been possible without savings dollars, and spending those funds would not have been possible if borrowers were not willing to borrow. In this case, both savings and spending drive the economy. But what happens if the investor decides to spend the money she would have used to purchase a corporate bond?

    When a consumer makes purchases, GDP increases in the short run. In fact, we often see the quarterly fluctuations in economic activity being driven by consumer spending, which is the largest component of GDP. However, the impact on GDP is short-lived. These purchases, while increasing current economic activity and driving the economy in the short run, has no long-run impact on economic growth. It does not increase the productivity of the country, so it does not have a lasting effect. Consumer spending is necessary to stimulate the economy in the short run and deter it from slipping into recessions, but in the long run, it won’t directly increase a country’s ability to produce goods and services.

    Traditionally, personal savings rates have been low in the U.S. and in recent years have climbed to around 5 percent (BEA, 2014). Is this sufficient savings to drive economic growth in this country? Where does the U.S. get savings dollars if households are not willing to save? The answer lies with foreign investors. When domestic savings is not adequate to meet the demand of domestic borrowers, borrowers will turn to international investors to obtain funding. This seems like a simple solution to the borrowing problem, but there is another issue. All borrowed funds, whether borrowed from domestic or international investors, must be repaid. During repayment, borrowers’ consumption is likely to fall, which decreases economic activity. Therefore, borrowing may have negative effects on the economy in the long run.

    As you can see, there appears to be a balance between savings and spending that drives current economic activity and leads to longterm economic growth. So, should you save that next dollar or spend that next dollar? Which is better for the economy? The answer is: both!

     

    References 

    “PERSONAL INCOME AND OUTLAYS, JUNE 2014; REVISED ESTIMATES 1999 THROUGH MAY 2014” Bureau of Economic Analysis.  http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm. Accessed: August 12, 2014.

     

    Heather Luea is an academic department chair at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.

    The contents of this article are presented for informational purposes only. Always check with a professional regarding any questions you may have regarding financial services.

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