An Introduction to Demand Management, Long-Run Growth and Global Economic Governance
Chapter 4: Why I=S and What That Means: The Building Blocks of Macroeconomic Analysis
Most macroeconomic analyses use conventions that make the calculations much easier and the analysis more transparent. One particularly useful abstraction is that we will deal with a one-good-economy in our analysis of the Earth economy. The economy both produces and consumes this good. People can eat it, can sleep and live in it, use it to go to work and there they can use the good to produce other goods. The distinguishing character of this ‘one-goodness’ is that the good is a consumption good if it is actually consumed and that it is an investment good if not (you will recognize that this convention fits in nicely with definitions applied in the Planet Accounts that we discussed in Chapter 2). Therefore, for example, an apple that is not consumed is an investment good since it is stored and inventories are by definition part of investment. So by definition we have that production Q equals the total of consumption C and investment I so that Q = C + I. Since this equation follows from a definition (and thus always is true), we call this a definitional equation. In the same spirit, we define that a consumer can either spend his income on consumption or save so that saving equals the amount of income that is not consumed. This yields the definitional equation Y = C + S. Again by definition (you will recognize the Planet Accounts conventions again) Q = Y and by implication we have I = S. (At this stage we do not include the government in our analysis yet; so there is no government spending and there are no taxes. Some think of this as Paradise before the Fall of Man).
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