Putting money into savings is a good thing, right? Believe it or not, there's a down side when businesses and individuals save too much. Money in savings is said to have leaked out of the business-consumer cycle, ultimately reducing demand for goods and services, slowing production and negatively impacting the job market.
Leakage is an economic term referring to money that is not available to spend on wages, goods or services. It applies to both consumer households and businesses.
Leakage is the capital or income that leaves an economy instead of remaining in it. An example of leakage is when a consumer household decides to put a sum of money in a retirement account instead of buying new kitchen appliances. As another example, investors may put their money in a foreign enterprise because the return on investment is greater than a comparable domestic one. Both actions take money out of the domestic economy.
To understand leakage, it's helpful to first understand gross domestic product. A country's gross domestic product measures the gross market value of domestic goods and services in a given year. Changes in the GDP relative to other periods indicate whether an economy is expanding by producing more goods and services or contracting because of less output.
The United States GDP, which currently measures about $21 trillion dollars, has four components:
- Personal consumption expenditures
- Gross private investment
- Government purchases
- Net exports
Gross domestic product is an indicator of the overall well-being of the economy. Policymakers use GDP and related statistics to inform decisions on taxes, interest rates and trade policies. Changes in GDP affect business conditions and investment decisions. GDP affects whether workers are able to find employment.
When there is leakage of money out of the economy, it is unavailable to build the economy or even sustain it at the current level. GDP drops without the spending that propels it. The circular flow model explains how this works.
In its simplest form, the circular flow model has two sectors: households and businesses. The household sector sells its resources to the business sector and receives income in exchange.
With the labor and other resources it receives from the household sector, the business sector produces goods and services, which it sells to the household sector. In this model, money flows in one direction while resources and products flow in the opposite direction.
As long as everyone in the model spends all the money they receive in income, the business sector has enough to hire employees and buy resources. However, when households decide to save some of their income, they reduce their purchases of goods and services as they put money into bank accounts, mutual funds and other savings instruments.
Leakage is also due to taxes, not just savings. Money paid in taxes is money that is unavailable to consumers to spend on goods. Tax cuts are designed to inject money back into the economy, although this can mean cuts in government services for some.
Purchases of imported goods cause leakage as well. Businesses and consumers may be spending, but by purchasing foreign-made goods, they're putting money into the economies of other nations rather than the domestic economy.
Injection in the U.S. economy refers to putting money back into circulation. The government bailouts of the auto industry and financial institutions are two examples of large-scale injections that put money back into the U.S. economy to help pull the country out of recession.
Understanding the basics of the circular flow in an economy highlights the importance of leakages and injections. Leakages must be rectified by injections, otherwise the economy stagnates or declines.
With that money leaking out of the circular flow, businesses lack the cash to hire and purchase resources, which could lead to unemployment and recession without a way to introduce the money back into the system. The solution to this dilemma is to add a financial sector. The financial sector takes the savings and lends it to businesses, and in doing so, it injects the leaked money back into the system.