I have read your site for years, but this is the first time I felt compelled to ask a question: some friends and I were discussing the various benefits to society that would accrue from say, my purchasing a product, vs investing the same amount of money in the stock market. While I know, at a high level, that investment is necessary to grow the economy, I had a more difficult time explaining the specific mechanism by which the action of "I buy 100 bucks of index funds on Vanguard" translates to "investment" in the economy. We were easily able to understand that if I buy a 100 dollar widget from Widget Corp, that benefits that company (and the economy), which now has $100 more to spend on wages or machines, but I am having difficulty coming up with a similar concrete sequence of steps for the 100 dollar stock investment.
On a larger point, I think this reflects part of the skepticism and suspicion that people have towards the stock market, particularly from the crowd that throws around terms like "gambling" and "speculation."
This is a surprisingly confusing subject. Consider the sentence that begins "We were easily able to understand . . . ". In fact, I don't think they do understand, as money spent on wages and machines is not a benefit to the economy, it's a cost. The benefit comes from consuming the widget. In the examples that follow, I'll assume the $100 widget is a meal at a restaurant for the Moore family.
Before considering Brian's stock market question, suppose he were trying to decide between spending the $100 on a meal, or spending it on materials for a new front sidewalk. The meal is considered consumption, and the new sidewalk is investment, because it's durable and yields a flow of services for many years, or even decades. The money spent on the sidewalk is called "saving". In either case, output gets produced and the effect on GDP is roughly the same, in the short run. In the long run, GDP will be a bit higher with the sidewalk investment, as it will continue to produce a flow of services for many years.
Now suppose Brian is trying to decide between the $100 meal and loaning $100 to a neighbor who will install the sidewalk. So far things are the same, at least in the aggregate. But now suppose the neighbor waits 2 weeks to do the sidewalk project. In that case, the restaurant meal may lead to more GDP in the very short run (less than 2 weeks), as compared to loaning the money to the neighbor. Over a three week period, output is the same either way.
Now suppose Brian is trying to decide between spending $100 on a meal, or investing $100 in the stock of a company that will use the money to install sidewalks. This is still pretty much the same as the previous example of the loan to the neighbor, it's just that the financial arrangements are getting steadily more complicated---more reliance on financial intermediaries. It's still true that money saved leads to investment, but the connection gets progressively more difficult to see.
So far we've been assuming full employment, and in the end I'd argue that this is the correct assumption for answering Brians's question. But first I'd like to play the devil's advocate (aka Keynes's advocate). Let's assume that Brian's purchase of stock does not lead to more investment. The company does not respond by building more sidewalks. What then?
My response is that S=I is an identity, and that more saving implies more investment.
The devil would respond that that's true in aggregate, ex post, but also that Brian's extra saving would not cause aggregate saving to rise, for "paradox of thrift" reasons. His decision not to go out to eat would lower AD, pushing the economy into a tiny recession. Consumption would be $100 lower than if he had bought the meal, but investment would not rise, nor would saving, in the aggregate. Instead, the extra $100 in Brian's saving would be offset by $100 less in saving by someone else, perhaps the owner of the restaurant that saw a lower income when Brian did not eat out.
This devil's advocate position explains why people tend to think it's "good for the economy" if consumers spend a lot of money. But is it? That depends on monetary policy. If the Fed targets interest rates, then the devil is correct. An attempt by Brian to save a bit more will put downward pressure on interest rates. To keep them from falling the Fed will reduce the money supply a bit, and NGDP will fall. Instead of Brian's saving leading to more investment, it will lead to lower NGDP.
My response is that over any meaningful time frame the Fed does not target interest rates, they adjust them as needed to keep inflation or NGDP on target. This means the Fed provides enough "aggregate demand" so that when Brian tries to save more, NGDP does not fall. Instead, that $100 boosts investment somewhere in the economy.
I don't mean to suggest that this works perfectly, rather that it works on average. Sometimes the Fed injects a bit too much money, and sometimes not enough. That's because they are not watching Brian as he ponders whether to spend $100 at the restaurant. So his decision not to eat out will cause a drop in NGDP at that very moment, relative to the alternative decision to buy the meal. The Fed tries to guess how people are behaving in the aggregate, and tries to supply enough money so that the classical model is true, that is, enough money to keep aggregate demand growing at the Fed's target rate.
Since monetary policy works on average, it's the default assumption that Brian and his friends should make when thinking about consumption and saving.