If money saving and investment spending are in equilibrium, the economy will be in equilibrium, for the decisions of consumers, savers, investors, and entrepreneurs will not affect either in an increase or decrease in employment, output and money income.
The circular flow of expenditure, and hence, the income stream, remains constant. In such a situation, effective demand remaining unchanged, the profit expectations of entrepreneurs are exactly realised, and will presumably continue to offer employment at the same level.
The economic system is then in equilibrium but such equilibrium may not necessarily be at full employment level; it may be at a level far below full employment. Thus, saving-investment equality is possible at the underemployment equilibrium level of the economic system.
According to Keynes, in a functional sense, thus, the equality between investment and saving is a consequence of changes in the level of income. To him, the equality between the saving and investment functions is an indispensable condition of equilibrium.
No level of national income can be sustained without the equality of aggregate saving and aggregate investment. And, he stressed the point that income is the functional variable that brings about equality between saving and investment.
It may be noted here that classical economists had also visualised the functional equality between saving and investment but they believed that it was brought about by the rate of interest.
In their view, if saving and investment are unequal at a certain time, they will soon be brought into equilibrium by changes in the rate of interest. Given the rate of investment, if saving increases, then the rate of interest will fall.
With the decline in the rate of interest, investment demand will rise. But the fall in the rate of interest will affect the volume of saving adversely. Hence, through the expansion process in investment and a contraction in saving, ultimately, the equality between saving and investment will be brought about.
The rate of investment will change as long as increased saving is reduced and investment is increased to attain an equilibrium point. Conversely, when saving decreases, the rate of interest will rise to boost saving and curtail investment so that once again the equilibrium of saving and investment is achieved. Thus, to the classicists, the rate of interest is the equilibrating variable between saving and investment.
Moreover, classical economists visualised equality between saving and investment at the point of full employment only. Thus, the classical notion of monetary equilibrium is one in which savings flow automatically into an equal amount of investment via changes in the interest rate to give full-employment level of income.
Keynes, however, held on entirely different view. To him, national income and not interest rate acted as the equilibrating variable between saving and investment.
In his concept of functional equality of saving and investment, savers and investors react to income variations in such a way that their desire to save and invest is expected to be harmonised in the very process of these reactions.
Thus, if saving exceeds investment (that is to say, when investment decreases), saving remaining constant (because the saving schedule is a stable function of income), income will fall and, therefore, saving will also contract.
Income will continue to fall until the saving out of the lower income is equal to the reduced investment. Similarly, if investment increases, saving remaining constant (thus investment exceeding saving), income will rise until the saving out of the higher income is equal to the increased investment.
It should be noted that when investment exceeds saving, that is, when investment increases, a new equilibrium between saving and investment will materialise at a higher level of income; and, when saving exceeds investment, that is, when investment decreases, the new equilibrium between saving and investment will be at a lower income level.
Hence, Keynes considered a shifting equilibrium, in his income analysis, in terms of saving and investment equality as against the traditional analysis of full employment equilibrium, in which investment and saving are equal only at full employment.
Thus, Keynes differs from the classical theory, in that, in his theory, saving and investment can be, and normally are, equal to each other at the point of less than full employment.