There are three choices that market actors can make with their money. They can consume it by spending it on goods and services. For example, buying a movie ticket is spending money on consumption. They can also invest money by lending it to a company or project with the hope of getting back more money in the future. Finally, they can save it by putting it in a bank account (or keeping cash under the bed). Savings is essentially deferred consumption or investment; it is intended for use in the future.
In order to understand the effects of aggregate decisions of consumption, savings, and investment, we must look at aggregate demand (AD). AD is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels and is the demand for the gross domestic product of a country.
Components of Aggregate Demand
It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is downward sloping but in variation with microeconomics, this is as a result of three distinct effects: the wealth effect, the interest rate effect and the exchange-rate effect.
Basically individuals will consume or purchase more when they feel wealthier or have access to inexpensive funding.
The wealth effect is specifically related to the value of assets; market participants will adjust consumption in-line with their perception of the appreciation or depreciation of held assets (a home; equity investments, etc.). The interest rate effect has to do with access to inexpensive funding, which provides an incentive to increase current period expenditures; while the exchange-rate effect has to do with expenditure decisions related to imports or foreign related expenditures, as the exchange rate is perceived to be favorable to the domestic currency, expenditures on foreign items or imports will increase.
Consumption, Savings, and Investment
Aggregate demand met by the market is spending, be it on consumption, investment, or other categories.
Spending is related to income:
Income – Spending = Net Savings
Rearranging:
Spending = Income – Net Savings = Income + Net Increase in Debt
In words: what you spend is what you earn, plus what you borrow: if you spend $110 and earned $100, then you must have net borrowed $10; conversely if you spend $90 and earn $100, then you have net savings of $10, or have reduced debt by $10, for net change in debt of –$10.
For the economy as a whole, aggregate savings is greater than or equal to investment, which is usually in the form of borrowed funds available as a result of savings. Through investment spending, savings influences aggregate demand.
Furthermore, since consumption and investment are components of GDP but saving is not, increased savings indirectly reduces GDP .
US Savings Rate
Savings have declined in the US on aggregate since the 1980s, which means that the proportion of income spent on consumption and investment increased.