The Prior Saving Theory regards saving as a prerequisite of investment, and stresses the need for policies to mobilize saving voluntarily for investment and growth. The financial system has both the scale and structure effect on saving and investment. It increases the rate of growth (volume) of saving and investment, and makes their composition, allocation, and utilization more optimal and efficient. It activists saving or reduces idle saving; it also reduces unfructified investment and the cost of transferring saving to investment.
How is this achieved? In any economy, in a given period of time, there are some people whose current expenditures is less than their current incomes, while there are others whose current expenditures exceed their current incomes. In well-known terminology, the former are called the ultimate savers or surplus–spending-units, and the latter are called the ultimate investors or the deficit-spending-units.
Modern economies are characterized:
(a) By the ever-expanding nature of business organisations such as joint-stock companies or corporations
(b) By the ever-increasing scale of production,
(c) By the separation of savers and investors
(d) By the differences in the attitudes of savers (cautious, conservative, and usually averse to taking risks) and investors (dynamic and risk- takers).
In these conditions, which Samuelson calls the dichotomy of saving and investment, it is necessary to connect the savers with the investors. Otherwise, savings would be wasted or hoarded for want of investment opportunities, and investment plans will have to be abandoned for want of savings. The function of a financial system is to establish a bridge between the savers and investors and thereby help the mobilization of savings to enable the fructification of investment ideas into realities. Figure below reflects this role of the financial system in economic development.