Consumption or Saving

Econ 101

You’ve heard it before, consumption is good for the economy.

This is a myth - though, like all good myths, it contains a grain of truth.

To tease this apart, it helps to split GDP into two parts: potential GDP and the output gap: $$GDP = (Potential GDP) - (Output Gap)$$

In the short-run, companies can meet increased demand by pushing their employees to work more hours or by hiring less and less qualified employees. Likewise, they can cut costs by firing employees or cutting back their hours.

However, in the long run, when lots of companies demand more labor, wages rise, and subsequently the number of hours required fall. Likewise, when companies are cutting back, wages fall until hiring employees becomes productive again. At least, this is what happens in sufficiently free labor markets.

In the long-run, however, we tend always towards an equilibrium, where unemployment is around 5% and where GDP neither exceeds nor falls short of its long-term potential. Ths potential changes not because of the whims of investor/consumer feelings, but due to economic fundamentals.

[todo: insert chart]
Unemployment tends towards 5%.

Economists pretty much all agree that increasing consumption helps a country get out of a recession. When more people spend money, we see inflation, which reduces real wages, which increases labor demand, causing unemployment to fall, and voila no more recession.

However, our country can’t produce more in the long-run just by wanting to buy more things. To increase potential GDP, we have to actually improve our ability to produce - that's what investment does. So, the natural question is whether we should subsidize investment to help the economy.

Investment Analysis

However, it's also not the case that you saving/investing money helps "the economy". Simple economics requires that the the marginal profit generated by increased investment accrues entirely to the investor.

If you save more, all you'll achieve is lowering the interest rate and causing a zero-sum shift in income from non-you capitalists to laborers [show].

In short, the net externality is 0 for both consumption and investment, so standard economic theory suggests that we shouldn't care about subsidizing one or the other.


Well, there's economics and then there's utilitarianism.

There are pleanty of complicating factors:

  1. People aren't rational and (due to hyperbolic discounting) generally won't save enough for their own good.
  2. People earning mostly capital income tend to be wealthier than people earning mostly labor income. Hence, we may be able to gain utility by giving preferential treatment to laborers over capitalists.
  3. On the other hand, if I save, I cause (as a side effect) a zero-sum transfer from capitalists to laboreres. Likewise, if I work longer hours, I cause a transfer from laboreres to capitalists. This effect is the opposite of (2).

On the other hand, we have the Atkinson-Stiglitz Theorem, which says that, really, we shouldn't be taxing capital income at all under a utilitarian framework "title": "Optimal capital income taxation" and all these redistributive worries can be taken care of with a sufficiently progressive tax on just labor income - of course, this assumes people's saving decisions are rational.

Given all this, there doesn't seem to be a strong argument for favoring either capital or labor income, but I should consider this further.

Works Cited [show]