4.2.2 How the macroeconomy works: the circular fow of income, aggregate demand/aggregate supply analysis and related concepts

To what extent do you agree that a fall in savings is beneficial to the economy [25 marks]

Savings are calculated by assumption from income. The formula savings = income - consumption is used to calculate what proportion of income is saved. A fall in savings, therefore, shows a greater proportion of income being spent on consumption. In my opinion, I believe a fall in savings is quite beneficial to an economy in the short run. However, when it comes to the long run, falling savings can have detrimental impacts.

Savings are seen as a withdrawal from the circular flow of income; a leakage of spending power out of the circular flow. Therefore, by reducing the amount of savings, we are injecting more into the economy, whether that be through investments, exports, or increased government spending. In the short run, increased consumption can lead to an increased output as households spend more on goods and services. Consumption is a key component of aggregate demand:

AD = C + I + G + (X - M)

With an increase in consumption, there may be a boost in GDP. A rise in GDP, catering to purchasing power, may result in the UK achieving growth targets and reducing unused slack in the economy.

For the long run, a sustained fall in savings may incentivize firms to invest in an increased capacity of stock, expecting higher demand. However, it could also be argued that if banks have fewer deposits, they may not be able to lend to firms, and hence, aggregate demand may stagnate. This can be shown through the diagram (Keynsian diagram with demand pull inflation)

The diagram indicates how, despite consumption increasing aggregate demand and shifting it outwards, the real national output marginally increases compared to price levels. Furthermore, increased aggregate demand through higher consumption may be problematic for countries such as the UK that have consumption-based economies. Despite an economic boom in the short run, this will most likely not be sustainable. This may cause firms to raise prices as they are unable to meet demand, which may reduce purchasing power and therefore harm lower-income households. This could contribute to income inequality. Demand-pull inflation will increase nominal GDP but not real GDP.

A fall in savings may also increase the number of imports. This could lead to the worsening of the trade deficit on the UK's current account, hence negatively impacting the balance of payments. An increase in imports also reduces aggregate demand, which reduces GDP and, consequently, living standards.

An example of where sustained low savings had significant consequences is the 2008 financial crisis, where low savings caused a higher amount of borrowing and spending, fueling unsustainable economic growth. As the crisis hit, lower savings left households vulnerable, and many were unable to survive the downturn. On the other hand, unemployment can be significantly reduced when spending increases. For instance, increased consumption in the UK post-COVID-19 pandemic enabled unemployment to be reduced from 5.2% to 4.1% between 2020 and 2022. It could be argued that in a fully employed country, increasing consumption only increases inflationary pressures.

Increased consumption from reduced savings may cause the depreciation of the pound due to the high demand for imports. This could result in UK exports becoming relatively cheaper abroad, improving the trade balance. However, there may be a trade-off, as exports may also become less competitive.

While researching this, I found something called the  However, consumption-based economies like the UK tend to spend and invest rather than innovate, which could be problematic in the long run. In an economy with a high marginal propensity to consume, households tend to spend a greater proportion of their income, which is not likely to be sustainable. Therefore, I somewhat agree that a fall in savings is beneficial for an economy as it increases aggregate demand and helps a country emerge from a recession. However, this is not sustainable in the long run.

Feedback:

Grade: A

Comment: Maybe a bit more on saving being the source of funds for investment. But this is excellent!