Maintaining a strong economy is an important policy objective that gives everyone employment opportunities and a good standard of living. Consumer spending is the driving force in the U.S. economy, accounting for approximately 70 percent of the gross domestic product. If savings diminish that spending, it creates a leak in the system by siphoning money out of consumption.
Money, Resources and Products Move in Circular Movements
The model that best explains how savings is a leakage in the economy is the circular flow model. In its simplest form it 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 flows in the opposite.
What Leaks Out Must Be Injected Back In
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. But 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. 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 injects the leaked money back into the system.
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