On Saving, Part 1

Perhaps the greatest lesson that ordinary people have learned from the current economy is the importance of savings. The media reports that people, specially Americans, are saving more then ever before. But is this a good time to save?

What is savings and Why do people save?

The classic economic definition of savings is disposable income minus consumption, i.e. your remaining income after tax take away how much you've spent. Then people would deposit the money into a financial institution(or put it under the pillow). When they need money in the future, they would withdrawal the money and spend it(the economic term is dissaving).

Then the reason people save money is to use the money in the future. In other words, one's saving is one's future consumption.

On the other hand, at the macroeconomic level, saving has a tight connection with investment.

What banks do with our savings?

When you save, the most common thing for you to do is to deposit the money into an account in a bank, but do you think the bank will let its deposit sits in the vault? Never will a bank engage in such activity. The reason is when banks let seposits stay at the vault, even they are not doing anything with the deposits, they are losing money.

This could be explained by opportunity cost.

The classic definition of opportunity cost is the amount you have to forgo when you choose one option instead of the next best option.

In the case of the banks, their next best option is to lend out the deposits with interest. Clearly, the banks are forgoing the interest they would charged if they decided to keep the deposits in the vault.

Given these two choices, any reasonable banker would lend out the deposits instead of keeping them in the vault.