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The Relationship between Saving and Investment!

An important controversy in macroeconomics relates to the relationship between saving and investment. Many economists before J.M. Keynes were generally of the view that saving and investment are generally not equal; they are equal only under condition of equilibrium. Besides, they thought that equality between saving and investment is brought about by changes in the rate of interest. Keynes in his famous work &#;General Theory of Employment, Interest and Money&#; put forward the view that saving and investment are always equal.

This gave rise to a severe controversy in economics as to whether saving and investment are always equal or they are generally unequal. This controversy has now been resolved, and there is general agree­ment among the economists about the correct relationship between saving and investment.

Mod­ern economists use the concepts of saving and investment in two different senses. In one sense, saving and investment are always equal, equilibrium or no equilibrium. In the second sense, saving and investment are equal only in equilibrium; they are unequal under conditions of disequilibrium. We shall explain below in detail the relationship between saving and investment in these two different senses.

When in a certain year there is net addition to the stock of capital, investment is said to have taken place. It is worth mentioning here that by investment we do not mean the stock of capital but the net addition to the stock of capital i.e., investment is a flow concept. Of course, addition to the stock of capital is made through the flow of investment. In every year stock of capital expands through net investment.

On the other hand, by saving we mean the part of the income which has not been spent on consumer goods and services. In other words, saving is the difference between income and consumption expenditure. It is worth noting that in consumption expenditure all types of expenditure are not included. If an individual spends a part of his income on providing irrigation facilities, on buying tools and machinery, then that expenditure is not the consumption expenditure, it is in fact an investment expenditure.

In order to obtain the saving, we have only to deduct the consumption expenditure from income and not the investment expenditure. When an individual makes investment expenditure he is deemed to spend his saved income on investment. For instance, if a farmer&#;s annual income is Rs. 10, and he spends Rs. 6, on consumer goods and services and spends Rs. 1, on the construction of a well for his fields, and another Rs. 1, on building a drainage system for his fields and providing fencing, then his saving would be 10 &#; 6 = Rs. 4 thousands.

The expenditure of Rs. 2, on well, drainage and fencing will be included in the saving and will not constitute the consumption expenditure. If Y represents the national income of a country and C the total consumption, then the saving of the country will be equal to Y &#; C. Thus,

S = Y &#; C

Ex-post Savings and Ex-post Investment are always equal:

Pre-Keynesian economists were of the view that savings and investment are generally not equal. This is firstly because saving and investment are made by two different classes of people. While investment is undertaken by entrepreneurial class of the society, saving is done by the general public. Secondly, saving and investment depend upon different factors and are made for different purposes and motives.

Therefore, it is not inevitable that savings and investment of a society must always be equal. Besides, some pre-Keynesian economists pointed out that invest­ment expenditure is also undertaken by borrowing money from the banks which create new credit for this purpose.

It was thus pointed out that more amount of investment than savings is possible because excess of investment over savings is financed by new bank credit. But Keynes expressed a totally opposite view that saving and investment are always equal. The sense in which savings and investment are always equal refers to the actual savings and actual investment made in the economy during a year.

They are also called ex-post saving and ex-post investment. If we have to calculate that during the year , how much actual savings and investment have been made in India, we will have to deduct the total consumption expenditure made by the citizens of India during that year from the national income.

Likewise, the real investment during the year of the Indian economy will be obtained by summing up the investments actually made by the Indian people during that year. In fact, national income estimates of savings and investment are made in this actual or ex-post sense.

The second sense in which saving and investment words are used is that in a certain year how much saving or how much investment people of the country desire or intend to do. There­fore, saving and investment in this sense are known as desired, intended or planned savings and investment. They are also called ex-ante saving and ex-ante investment.

Keynes in his book, &#;General Theory of Employment, Interest and Money&#; showed that in spite of the fact that saving and investment are done by two different classes of people and also for different purposes and motives, actual saving and actual investment are always equal.

Thus, he used the word saving and investment in the ex-post or actual sense and proved the equality between saving and investment in the following way:

Income of a country is earned in two ways:

(1) By producing and selling consumer goods and services, and

(2) By producing and selling capital goods.

That is, national income of a country is composed of the value of consumer goods and services and the value of capital goods.

This can be expressed in the form of the following equation:

National Income = Consumption + Investment

or

Y = C + I

where Y stands for national income, C for consumption and I for investment.

The above equation represents the production or earning side of the national income. The second aspect of national income is the expenditure side. The total national income can be fully consumed but generally it does not happen so. In actual practice, a part of the total income is spent on consumption and the remaining part is saved.

From this we get the following equation:

National Income = Consumption + Saving

Or

Y = C + S

where Y stands for national income, C for consumption and S for saving.

In the above two equations (i) and (ii) it is clear that national income is equal to the sum of consumption and investment and also equal to the sum of consumption and saving.

From this it follows that:

Consumption + Saving = Consumption + Investment

C + S = C + I

In equation (iii) above, since C occurs on both sides of the equation, we get:

Saving = Investment

or

S = I

From the foregoing analysis, it follows that saving and investment are defined in such a ay that they are necessarily equal to each other. In equation (i) investment is that part of national income which is obtained from the production of goods other than those consumed and equation (ii) saving is that part of national income which is not spent on consumption.

Hence the actual or ex-post sense, saving and investment by definition are equal. It is worth mentioning that in macroeconomics, saving and investment do not refer to the saving and investment by an individual; they refer to the saving and investment of the whole community or economy. Saving and investment by an individual can differ but in the ex-post sense, the saving of the whole country must always be equal to the investment.

Now the question arises, why ex-post saving and ex-post investment are always equal. For instance, when more investment is undertaken by the entrepreneurs how actual saving becomes equal to this larger investment and if the saving falls how investment will become equal to smaller savings. In this connection it is worth mentioning that modern economists, as did Keynes, include the addition to the inventories of consumer goods in investment.

Now, when saving increases, it implies that consumption will be less. The decline in consumption would result in the addition to the inventories of consumer goods with the shopkeepers and manufacturers, which were not planned or intended by them. This addition to inventories, though unintended, will raise the level of actual investment.

Thus unintended increase in inventories will raise the level of investment and in this way investment will increase to become equal to the greater saving. On the other hand, if in any year saving declines, it will result in the unplanned decline in the inventories of consumer goods with the traders and manufacturers. This unintended decline in inventories will mean the fall in actual investment. In this way, investment will decline to become equal to the lower savings.

Ex-ante saving and Ex-ante Investment are Equal only in Equilibrium:

As said above, in the desired, planned or ex-ante sense, saving and investment can differ. In fact planned or ex-ante saving and investment are generally not equal to each other. This is due to the fact that the persons or classes who save are different from those who invest.

Savings are done by general public for various objectives and purposes. On the other hand, investment is made by the entrepreneurial class in the community and is generally governed by marginal efficiency of capital on the one hand and rate of interest on the other hand.

Therefore, savings and investment in planned or ex-ante sense generally differ from each other. But through the mechanism of change in the income level, there is tendency for ex-ante saving and ex-ante investment to become equal.

When in a year planned investment is larger than planned saving, the level of income rises. At a higher level of income, more is saved and therefore intended saving becomes equal to intended investment. On the other hand, when planned saving is greater than planned investment in a period, the level of income will fall.

At a lower level of income, less will be saved and therefore planned saving will become equal to planned investment. We thus see that planned or ex-ante saving and planned or ex-ante investment are brought to equality through changes in the level of income. When ex-ante saving and ex-ante invest­ment are equal, level of income is in equilibrium i.e., it has no tendency to rise or fall.

It is thus clear that whereas realised or ex-post saving is equal to realised or ex-post investment, intended, planned or ex-ante saving and investment may differ; intended or ex-ante saving and investment have only a ten­dency to be equal and are equal only at the equi­librium level of income.

That the planned or intended saving is equal to intended investment only at the equilibrium level of income can be easily understood from Fig. In this figure, national income is measured along the X-axis while saving and investment are measured along the Y-axis.

SS is the saving curve which slopes upward indicating thereby that with the rise in income, saving also increases. II is the investment curve. Investment curve II is drawn as horizontal straight line because, following Keynes, it has been assumed that investment is independent of the level of income i.e., it depends upon factors other than the current level of income.

It will be seen from the Fig. that saving and investment curves intersect at point E. Therefore, OY is the equilibrium level of income. If the level of income is OY₁, the intended investment is Y₁H whereas the intended saving is Y₁L. It is thus clear that at OY₁ level of income, intended investment is greater than intended saving.

As a result of this, level of income will rise and at higher levels of income more will be saved. It will be seen that with the rise in income to OY₂, saving rises and becomes equal to investment. On the other hand, if in any period, level of income is OY₃ intended investment is Y₃K and intended saving is Y₃J. As a result of this, level of national income will fall to OY₂ at which ex-ante saving and ex-ante investment are once again equal and thus level of national income is in equilibrium.

To sum up, whereas ex-post savings and ex-post investment are always equal, ex-ante saving and ex-ante investment are equal only in equilibrium.

More Formally

In symbols, we write the consumption function as a relationship between consumption (C) and disposable income (Y^d):

where a and b are constants. Here a represents autonomous consumption and b is the marginal propensity to consume. We assume three things about a and b:

1. a > 0
2. b > 0
3. b < 1

The first assumption means that even if disposable income is zero (Y^d = 0), consumption will still be positive. The second assumption means that the marginal propensity to consume is positive. By the third assumption, the marginal propensity to consume is less that one. With 0 < b < 1, part of an extra dollar of disposable income is spent.

What happens to the remainder of the increase in disposable income? Since consumption plus saving is equal to disposable income, the increase in disposable income not consumed is saved. More generally, this link between consumption and saving (S) means that our model of consumption implies a model of saving as well.

Using

and

we can solve for S:

So −a is the level of autonomous saving and (1 − b) is the marginal propensity to save.

We can also graph the savings function. The savings function has a negative intercept because when income is zero, the household will dissave. The savings function has a positive slope because the marginal propensity to save is positive.

Economists also often look at the average propensity to consume (APC), which measures how much income goes to consumption on average. It is calculated as follows:

When disposable income increases, consumption also increases but by a smaller amount. This means that when disposable income increases, people consume a smaller fraction of their income: the average propensity to consume decreases. Using our notation, we are saying that using C = a + bY^d, so we can write

An increase in disposable income reduces the first term, which also reduces the APC.

The Main Use of This Tool

Marginal Propensity to Consume vs. Marginal Propensity to Save: An Overview

Historically, consumer demand and consumption have helped drive the U.S. economy. When American consumers have a greater amount of extra income, they might spend a portion of it, thereby spurring growth in the economy. Consumers might also save a portion of their extra income.

These tendencies aren't mere observations but are the basis for the marginal propensity to save (MPS) and the marginal propensity to consume (MPC).

Marginal Propensity to Save

The marginal propensity to save (MPS) is the portion of each extra dollar of a household’s income that's saved. The MPS indicates what the overall household sector does with extra income—specifically, the percent of extra income that is saved.

As saving is a complement of consumption, the MPS reflects key aspects of a household’s activity and its consumption habits. It is expressed as a percentage. For example, if the marginal propensity to save is 10%, it means that out of each additional dollar earned, 10 cents is saved.

The marginal propensity to save is calculated by dividing the change in savings by the change in income. For example, if consumers saved 20 cents for every $1 increase in income, the MPS would be (/$1) or 20%.

The MPS reflects the savings amount or leakage of income from the economy. Leakage is the portion of income that's not put back into the economy through purchases of goods and services. The higher the income for an individual, the higher the MPS as the ability to satisfy needs increases with income. In other words, each additional dollar is less likely to be spent as an individual becomes wealthier. Studying MPS helps economists determine how wage growth might influence savings.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is the flip side of MPS. MPC helps to quantify the relationship between income and consumption. MPC is the portion of each extra dollar of a household’s income that is consumed or spent. For example, if the marginal propensity to consume is 45%, out of each additional dollar earned, 45 cents is spent.

Economic theory tends to support that as income increases, so too does spending and consumption. MPC measures that relationship to determine how much spending increases for each dollar of additional income. MPC is important because it varies at different income levels and is the lowest for higher-income households.

The marginal propensity to consume is calculated by dividing the change in spending by the change in income. For example, if consumers spent 80 cents for every $1 increase in income, the MPC would be (/$1) or 80%.

For example, imagine that Congress wants to enact a tax rebate to spur economic activity through consumer spending. MPC can be used to assess the likelihood of which household's, based on their income, would have the greatest likelihood or propensity to spend the tax cut, rather than save it.

The MPC percentage can also be used by economists to determine how much of each $1 in tax rebates will be spent. In doing so, they can adjust the total size of the rebate program to achieve the desired spending per household.

The MPC is also vital to the study of Keynesian economics, which is the result of economist John Maynard Keynes. Keynesian economics was developed during the s in an attempt to understand the Great Depression. Keynes advocated for increased government expenditures and lower taxes to stimulate demand and pull the global economy out of the depression. The extent to which stimulus adds to economic growth is called the Keynesian multiplier.

The MPC, like the MPS, affects the multiplier process and affects the magnitude of expenditures and tax multipliers. Ultimately, both MPS and MPC are used to discuss how a household utilizes its surplus income, whether that income is saved or spent. Consumer behavior concerning saving or spending has a very significant impact on the economy as a whole.

Before developing the Keynesian Aggregate Expenditures model, we must understand the basic macroeconomic relationships that are the components of that model. The components of aggregate expenditures in a closed economy are Consumption, Investment, and Government Spending. Because government spending is determined by a political process and is not dependent on fundamental economic variables, we will focus in this lesson on an explanation of the determinants of consumption and investment.

Section Consumption and Savings

In the simplest model we can consider, we will assume that people do one of two things with their income: they either consume it or they save it.

Income = Consumption + Savings

In this simple model, it is easy to see the relationship between income, consumption, and savings. If income goes up then consumption will go up and savings will go up. Consider the graph below, which shows Consumption as a positive function of Income:

Notice the use of the 45˚ degree line to illustrate the point at which income is equal to consumption. At that point, labeled E in our graph, savings is equal to zero. At income levels to the right of point E (like Io), savings is positive because consumption is below income, and at income levels to the left of point E (like I'), savings is negative because consumption is above income. How can savings be negative? If you thought of borrowing, you are right. In economics we call this “dissavings.” Point E is called the breakeven point because it is the point where there are no savings but there are also no dissavings. The graph below demonstrates the relationship between consumption and savings:

The Consumption Function

The Consumption Function shows the relationship between consumption and disposable income. Disposable income is that portion of your income that you have control over after you have paid your taxes. To simplify our discussion, we will assume that Consumption is a linear function of Disposable Income, just as it was graphically shown above.

C = a + b Yd

In the above equation, “a” is the intercept of the line and b is the slope. Let’s explore their meanings in economics. The intercept is the value of C when Yd is equal to zero. In other words, what would your consumption be if your disposable income were zero? Can there be consumption without income? People do this all the time. In fact, some of you students may have no income, and yet you are still consuming because of borrowing or transfers of wealth from your parents or others to you. In any case, “a” is the amount of consumption when disposable income is zero and it is called “autonomous consumption,” or consumption that is independent of disposable income.

In the consumption function, b is called the slope. It represents the expected increase in Consumption that results from a one unit increase in Disposable Income. If Income is measured in dollars, you might ask the question, “How much would your Consumption increase if your Income were increased by one dollar?” The slope, b, would provide the answer to that question. It is the change in consumption resulting from a change in income. (Remember the idea of a slope being the rise over the run? Go back to the graph of the consumption function and satisfy yourself that the rise is the change in Consumption and the run is the change in Income, and you will see that this definition of b is consistent with the definition of a slope.) In economics, “b” is a particularly important variable because it illustrates the concept of the Marginal Propensity to Consume (MPC), which will be discussed below.

The Savings Function shows the relationship between savings and disposable income. As with consumption, we will assume that this relationship is linear:

S = e + f Yd

In this equation the intercept is e, the autonomous level of Savings. With savings, it is quite likely that “e” will be negative, which indicates that when Disposable Income is zero, Savings on average are negative. The slope of the savings function is “f,” and it represents the Marginal Propensity to Save—the increase in Savings that would be expected from any increase in Disposable Income.

Marginal Propensities to Consume and Save

The Marginal Propensity to Consume is the extra amount that people consume when they receive an extra dollar of income. If in one year your income goes up by $1,, your consumption goes up by $, and you savings go up by $, then your MPC = .9 and your MPS = In general it can be said:

MPC = Change in Consumption/Change in Disposable Income = ∆C/∆Yd

MPS = Change in Savings/Change in Disposable Income = ∆S/∆Yd

It is also important to notice that: MPC + MPS = 1

Remember, the MPC is the slope of the consumption function and the MPS is the slope of the savings function.

Example

Let’s do an example using data for a hypothetical economy. The data is presented in the table below. From this data I will graph both the Consumption Function and the Savings Function and calculate the MPC and the MPS. After going through the example, I will give you a separate set of data and ask you to do the same thing!

Notice that as you move from an income of 15, to an income of 16,, consumption goes from 15, to 16, and savings goes from to 0. The MPC and MPS are therefore:

MPC = ∆C/∆Yd = / =

MPS = ∆S/∆Yd = / =

Since the Consumption Function and the Savings Function are both straight lines in this example, and since the slope of a straight line is constant between any two points on the line, it will be easy for you to verify that the MPC and the MPS are the same between any two points on the line. You can also see that that MPC + MPS =1 as was stated earlier.

Some of the Non-Income Determinants of Consumption and Savings

Notice that when we graph the Consumption Function, Consumption is measured on the vertical axis and disposable income is measured on the horizontal axis. As disposable income goes up, consumption goes up and this is shown by movement along a single consumption function. But there are other things that influence consumption besides disposable income. What if one of these non-income determinants of consumption changes? Since they are not measured on either axis, we should note that a change in a non-income determinant of consumption will shift the entire consumption function not merely move you along a fixed consumption function. Let’s look at several of these non-income determinants of consumption and savings:

1. Wealth—In economics wealth and income are two separate variables. A simple example will illustrate the difference. Let’s say that you have a job earning $50, a year. If your great aunt Maude dies and leaves you $, in an inheritance, your income is still $50, a year, but your wealth has just gone up. The same could be said about sudden increases in the value of a piece of art that you own, the discovery of oil on your property, or increases in the value of your stock portfolio. None of these occurrences increases your income, but they all increase your wealth. An increase in wealth will increase your consumption even at the same income level, and can be illustrated by an upward shift in both the Consumption Function and the Savings Function. Obviously, a decrease in wealth will have the opposite effect.
2. Expectations—There are times when consumers adjust their spending, based not on their actual income but rather on their expectations of future changes in their income. Changes in expectations will cause a shift in the curve, because consumption has changed without an actual chance in income. For example, if you think your income is going to go up in the future, you may consume more today. Not that we suggest this as a wise course of action, but it has been observed that some college seniors start to spend more once they have secured a job, even though that job (and its attendant income) will not start for a month or two. This behavior would be illustrated by an upward shift in the consumption function showing that your consumption has increased even though your actual disposable income has not. Likewise, if for some reason you were pessimistic about your future income (rumors floating around the company that layoffs were eminent) you might decrease your consumption, even though your actual current income had not changed.
3. Consumer Indebtedness—Consumers adjust their consumption to levels of indebtedness as well. We observe in the aggregate economy that when indebtedness goes up, consumption falls and savings rise. There is a level of debt beyond which consumers feel uncomfortable with additional spending. Even if income has stayed the same, if too much debt accumulates, consumers will start to spend less and pay off debt. This is illustrated by a downward shift in the Consumption Function and an upward shift in the Savings Function (remember that paying off debt is the same thing as increasing savings). The opposite is also true. At low levels of debt people will consume more and save less.

You can likely think of other factors that are unrelated to income that could shift the Consumption and Savings Functions. In general, anything that influences consumption or savings that is NOT disposable income will shift the Functions upward or downward. Any change in disposable income will move you along the Functions.

Return to the course in I-Learn and complete the activity that corresponds with this material.

Section The Interest Rate — Investment Relationship

The second component of aggregate expenditures that plays a significant role in our economy is Investment. Remember from our lesson on National Income Accounting that investment only occurs when real capital is created. Investment is such an important part of our economy because it affects both short-run aggregate demand and long-run economic growth. Investment is a component of aggregate expenditures, so when a company buys new equipment or builds a new plant/office building, it has an immediate short-run impact on the economy. The dollars spent on the investment have the immediate impact of increasing spending in the current time period. But because of the nature of investment, it has a long-term impact on the economy as well. If a company buys a new machine, that machine is going to operate, continue to produce, and will have an impact on the productive capacity of the economy for years to come. This is in contrast to consumption purchases that do not have the same impact. If you buy and eat an apple today, that apple does not continue to provide consumption benefits into the future.

Expected Rate of Return

An important question in the study of investment is, “Why do firms invest?” Investment is guided by the profit motive—firms invest expecting a return on their investment. Before the investment takes place, firms only know their expected rate of return. Therefore, investment almost always involves some risk.

Consider the following scenario. Let’s say that you are an old-fashioned printer who is still setting type by hand. You know that your equipment is slow and outdated. You also know that investing in modern computerized printing presses will yield a positive return for your business, but that they will be very expensive. A new press will cost you $, and you do not have $, sitting in your drawer at home. In order to undertake the investment in new equipment, you will have to borrow the money. Let’s say you have estimated the expected rate of return on the investment in new equipment to be %. Should you borrow the money and buy the new equipment? What will influence you decision?

The key variable that will help you to decide whether the investment makes sense for you is the real interest rate that you will have to pay on the loan. If the expected rate of return in greater than the real interest rate, the investment makes sense. If it is not, then the investment will not be profitable. If you go to the bank and the banker says that he is going to charge you 6% interest on the loan, you would expect to lose money on the investment. You cannot pay 6% on the loan if you only expect to earn % on the investment. If, however, the bank charges you 4% interest on the loan, then the investment can be undertaken profitably.

The real interest rate determines the level of investment, even if you do not have to borrow the money to buy the equipment. What if you did have $, sitting in your drawer, and you had to decide whether to buy machines that would yield an expected rate of return for your company of %. If the real interest rate at the bank is 6%, you would not buy the machines. You would instead put the money in the bank and earn 6%. If the interest rate at the bank were 4%, you would buy the machines because they will yield a higher return than the next best alternative available to you.

The Investment Demand Curve

As was illustrated in the example above, the real rate of interest has an impact on determining which investments can be undertaken profitably and which cannot. The higher the real rate of interest, the fewer investment opportunities will be profitable. When the real rate of interest is at 8%, only those investments that have an expected rate of return higher than 8% will be undertaken. If the interest rate is 4%, all investments with an expected rate of return higher than 4% will be undertaken. There are more investments with an expected rate of return higher than 4% than there are with an expected rate of return higher than 8%, so there is more investment at a lower rather than a higher real rate of interest. This inverse relationship between the real rate of interest and the level of investment is illustrated in the Investment Demand Curve shown below.

What Might Cause Shifts in the Investment Demand Curve?

As with the Consumption Function, there are factors that will shift the entire Investment Demand Curve. These are non-interest rate determinants of Investment. While there are many things that can influence the level of investment in the economy other than the real interest rate, we will discuss only three.

1. Business Taxes—The government can influence the level of investment by the tax structure they impose on businesses. When the government gives tax incentives for investing in new capital (such as allowing businesses to depreciate new capital at a faster rate, or giving tax credits for new “green” investments), this encourages additional investment at all levels of the real interest rate and shifts the Investment Demand Curve to the right. For example, in the graph below, if the real interest rate is r o, investment is at I o, the government gives tax incentives that encourage investment, then even at the same interest rate we might expect the level of investment to increase to I’. If the government withdraws these tax incentives, then the Investment Demand Curve shifts to the left.



2. Changes in Technology—A business will be more likely to increase investment in an industry where technology is changing than in an industry with a more fixed technology. Businesses recognize the need to keep up with competitors’ utilization of modern technology. At any given level of the real interest rate you would expect Investment Demand to be higher the more technology is advancing.
3. Stock of Capital Goods on Hand—Businesses that already have a significant stock of capital on hand are less likely to invest in additional capital. For instance, a company that has excess office space or idle plants is not as likely to invest in additional capital as a business that is operating at or beyond capacity. At any given level of the real interest rate, you would expect more investment by a firm that is short on capital goods than by a firm that has an adequate stock of capital on hand.

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Marginal Propensity to Consume vs. Marginal Propensity to Save: An Overview

Historically, consumer demand and consumption have helped drive the U.S. economy. When American consumers have a greater amount of extra income, they might spend a portion of it, thereby spurring growth in the economy. Consumers might also save a portion of their extra income.

These tendencies aren't mere observations but are the basis for the marginal propensity to save (MPS) and the marginal propensity to consume (MPC).

Marginal Propensity to Save

The marginal propensity to save (MPS) is the portion of each extra dollar of a household’s income that's saved. The MPS indicates what the overall household sector does with extra income—specifically, the percent of extra income that is saved.

As saving is a complement of consumption, the MPS reflects key aspects of a household’s activity and its consumption habits. It is expressed as a percentage. For example, if the marginal propensity to save is 10%, it means that out of each additional dollar earned, 10 cents is saved, relationship between income consumption investment and saving.

The marginal propensity to save is calculated by dividing the change in savings by the change in income. For example, if consumers saved 20 cents for every $1 increase in income, the MPS would be (/$1) or 20%.

The MPS reflects the savings amount or leakage of income from the economy. Leakage is the portion of income that's not put back into the economy through purchases of goods and services. The higher the income for an individual, the higher the MPS as the ability to satisfy needs increases with income. In other words, each additional dollar is less likely to be spent as an individual becomes wealthier. Studying MPS helps economists determine how wage growth might influence savings.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is the flip side of MPS, relationship between income consumption investment and saving. MPC helps to quantify the relationship between income and consumption, relationship between income consumption investment and saving. MPC is the portion of each extra dollar of a household’s income that is consumed or spent. For example, if the marginal propensity to consume is 45%, out of each additional dollar earned, 45 cents is spent.

Economic theory tends to support that as income increases, so too does spending and consumption. MPC measures that relationship to determine how much spending increases for each dollar of additional income. MPC is important because it varies at different income levels and is the lowest for higher-income households.

The marginal propensity to consume is calculated by dividing the change in spending by the change in income. For example, if consumers spent 80 cents for every $1 increase in income, the MPC would be (/$1) or 80%.

For example, imagine that Congress wants to enact a tax rebate to spur economic activity through consumer spending. MPC can be used to assess the likelihood of which household's, based on their income, would have the greatest likelihood or propensity to spend the tax cut, rather than save it.

The MPC percentage can also be used by economists to determine how much of each $1 in tax rebates will be spent. In doing so, they can adjust the total size of the rebate program to achieve the desired spending per household.

The MPC is also vital to the study of Keynesian economics, which is the result of economist John Maynard Keynes. Keynesian economics was developed during the s in an attempt to understand the Great Depression. Keynes advocated for increased government expenditures and lower taxes to stimulate demand and pull the global economy out of the depression. The extent to which stimulus adds to economic growth is called the Keynesian multiplier.

The MPC, like the MPS, affects the multiplier process and affects the magnitude of expenditures and tax multipliers. Ultimately, both MPS and MPC are used to discuss how a household utilizes its surplus income, whether that income is saved or spent. Consumer behavior concerning saving or spending has a very significant impact on the economy as a whole.

The Relationship between Saving and Investment!

An important controversy in macroeconomics relates to the relationship between saving and investment. Many economists before J.M. Relationship between income consumption investment and saving were generally of the view that saving and investment are generally not equal; they are equal only under condition of equilibrium. Besides, they thought that equality between saving and investment is brought about by changes in the rate of interest. Keynes in his famous work &#;General Theory of Employment, Interest and Money&#; put forward the view that saving and investment are always equal.

This gave rise to a severe controversy in economics as to whether saving and investment are always equal or they are generally unequal. This controversy has now been resolved, and there is general agree­ment among the economists about the correct relationship between saving and investment.

Mod­ern economists use the concepts of saving and investment in two different senses. In one sense, saving and investment are always equal, equilibrium or no equilibrium. In the second sense, saving and investment are equal only in equilibrium; they are unequal under conditions of disequilibrium, relationship between income consumption investment and saving. We shall explain below in detail the relationship between saving and investment in these two different senses.

When in a certain year there is net addition to the stock of capital, investment is said to have taken place. It is worth mentioning here that by investment we do not mean the stock of capital but the net addition to the stock of capital i.e., investment is a flow concept. Of course, addition to the stock of capital is made through the flow of investment. In every year stock of capital expands through net investment, relationship between income consumption investment and saving.

On the other hand, by saving we mean the part of the income which has not been spent on consumer goods and services. In other words, saving is the difference between young giftz money makin mitch and consumption expenditure. It is worth noting that in consumption expenditure all types of expenditure are not included. If an individual spends a part of his income on providing irrigation facilities, on buying tools and machinery, then that expenditure is not the consumption expenditure, it is in fact an investment expenditure.

In order to obtain the saving, we have only to deduct the consumption expenditure from income and not the investment expenditure. When an individual makes investment expenditure he is deemed to spend his saved income on investment. For instance, if a farmer&#;s annual income is Rs. 10, relationship between income consumption investment and saving, and he spends Rs. 6, on consumer goods and services and spends Rs. 1, on the construction of a well for his fields, and another Rs. 1, on building a drainage system for his fields and providing fencing, then his saving would be 10 &#; 6 = Rs. 4 thousands.

The expenditure of Rs. 2, on well, drainage and fencing will be included in the saving and will not constitute the consumption expenditure. If Y represents the national income of a country and C the total consumption, then the saving of the country will be equal to Y &#; C. Thus,

S = Y &#; C

Ex-post Savings and Ex-post Investment are always equal:

Pre-Keynesian economists were of the view that savings and investment are generally not equal. This is firstly because saving and investment are made by two different classes of people. While investment is undertaken by entrepreneurial class of the society, saving is done by the general public. Secondly, saving and investment depend upon different factors and are made for different purposes and motives.

Therefore, it is not inevitable that savings and investment of a society must always be equal. Besides, some pre-Keynesian economists pointed out that invest­ment expenditure is also undertaken by borrowing money from the banks list of active bitcoin addresses create new credit for this purpose.

It was thus pointed out that more amount of investment than savings is possible because excess of investment over savings is financed by new bank credit. But Keynes expressed a totally opposite view that saving and investment are always equal. The sense in top oil companies to invest in right now savings and investment are always equal refers to the actual savings and actual investment made in the economy during a year.

They are relationship between income consumption investment and saving called ex-post saving and ex-post investment. If we have to calculate that during the yearhow much actual savings and investment have been made in India, we will have to deduct the total consumption expenditure made by the citizens of India during that year from the national income.

Likewise, the real investment during the year of the Indian economy will be obtained by summing up the investments actually made by the Indian people during that year. In fact, national income estimates of savings and investment are made in this actual or ex-post sense.

The second sense in which saving and investment words are used is that in a certain year how much saving or how much investment people of the country desire or intend to do. There­fore, saving and investment in this sense are known as desired, relationship between income consumption investment and saving, intended or planned savings and investment. They are also called ex-ante saving and ex-ante investment.

Keynes in his book, &#;General Theory of Employment, Interest and Money&#; showed that in spite of the fact that saving and investment are done by two different classes of people and also for different purposes and motives, actual saving and actual investment are always equal.

Thus, he used the word saving and investment in the ex-post or actual sense and proved the equality between saving and investment in the following way:

Income of a country is earned in two ways:

(1) By producing and selling consumer goods and services, and

(2) By producing and selling capital goods.

That is, national income of a country is composed of the value of consumer goods and services and the value of capital goods.

This can be expressed in the form of the following equation:

National Income = Consumption + Investment

or

Y = C + I

where Y stands for national income, C for consumption and I for investment.

The above equation represents the production or earning side of the national income. The second aspect of national income is the expenditure side. The total national income can be fully consumed but generally it does not happen so. In actual practice, a part of the total income is spent on consumption and the remaining part is saved.

From this we get the following equation:

National Income = Consumption + Saving

Or

Y = C + S

where Y stands for national income, C for consumption and S relationship between income consumption investment and saving saving.

In the above two equations (i) and (ii) it is clear that national income is equal to the sum of consumption and investment and also equal to the sum of consumption and saving.

From this it follows that:

Consumption + Saving = Consumption + Investment

C + S = C + I

In equation (iii) above, since C occurs on both sides of the equation, we get:

Saving = Investment

or

S = I

From the foregoing analysis, it follows that saving and investment are defined in such a ay that they are necessarily equal to each other. In equation (i) investment is that part of national income which is obtained from the production of goods other than those consumed and equation (ii) saving is that part of national relationship between income consumption investment and saving which is not spent on consumption.

Hence the actual or ex-post sense, saving and investment by definition are equal. It is worth mentioning that in macroeconomics, saving and investment do not refer to the saving and investment by an individual; they refer to the saving and investment of the whole community or economy. Saving and investment by an individual can differ but in the ex-post sense, the saving of the whole country must always be equal to the investment.

Now the question arises, why ex-post saving and ex-post investment are always equal. For instance, when more investment is undertaken by the entrepreneurs how actual saving becomes equal to this larger investment and if the saving falls how investment will become equal to smaller savings. In this connection it is worth mentioning that modern economists, as did Keynes, include the addition to the inventories of consumer goods in investment.

Now, when saving increases, it implies that consumption will be less. The decline in consumption would result in the addition to the inventories of consumer goods with the shopkeepers and manufacturers, which were not planned or intended by them. This addition to inventories, though unintended, will raise the level of actual investment.

Thus unintended increase in inventories will raise the level of investment and in this way investment will increase to become equal to the greater saving. On the other hand, if in any year saving declines, it will result in the unplanned decline in the inventories of consumer goods with relationship between income consumption investment and saving traders and manufacturers. This unintended decline in inventories will mean the fall in actual investment. In this way, investment will decline to become equal to the lower savings.

Ex-ante saving and Ex-ante Investment are Equal only in Equilibrium:

As said above, in the desired, planned or ex-ante sense, saving and investment can differ. In fact planned or ex-ante saving and investment are generally not equal to each other. This is due to the fact that the persons or classes who save are different from those who invest.

Savings are done by general public for various objectives and purposes. On the other hand, investment is made by the entrepreneurial class in the community and is generally governed by marginal efficiency of capital on the one hand and rate of interest on the other hand.

Therefore, savings and investment in planned or ex-ante sense generally differ from each other. But through the mechanism of change in the income level, there is tendency for ex-ante saving and ex-ante investment to become equal.

When in a year planned investment is larger than planned saving, the level of income rises. At a higher level of income, more is saved and therefore intended saving becomes equal to intended investment, relationship between income consumption investment and saving. On the other hand, when planned saving is greater than planned investment in a period, the level of income will fall.

At a lower level of income, relationship between income consumption investment and saving, less will be saved and therefore planned saving will become equal to planned investment. We thus see that planned or ex-ante saving and planned or ex-ante investment are brought to equality through changes in the level of income. When ex-ante saving and ex-ante invest­ment are equal, level of income is in equilibrium i.e., it has no tendency to rise or fall.

It is thus clear that whereas realised or ex-post saving is equal to realised or ex-post investment, intended, planned or ex-ante saving and investment may differ; intended or ex-ante saving and investment have only a ten­dency to be equal and are equal only at the equi­librium level of income.

That the planned or intended saving is equal to intended investment only at the equilibrium level of income can be easily understood from Fig. In this figure, national income is measured along the X-axis while saving and investment are measured along the Y-axis.

SS is the saving curve which slopes upward indicating thereby that with the rise in income, saving also increases. II is the investment curve. Investment curve II is drawn as horizontal straight line because, following Keynes, relationship between income consumption investment and saving, it has been assumed that investment is independent of the level of income i.e., it depends upon factors other than the current level of income.

It will be seen from the Fig. that saving and investment curves intersect at point E. Therefore, OY is the equilibrium level of income, relationship between income consumption investment and saving. If the level of income is OY₁, the intended investment is Y₁H whereas the intended saving is Y₁L. It is thus clear that at OY₁ level of income, intended investment is greater than intended saving.

As a result of this, level of income will rise and at higher levels of income more will be saved. It will be seen that with the rise in income to OY₂, saving thieving money making guide eoc and becomes equal to investment. On the other hand, if in any period, level of income is OY₃ intended investment best performing investment funds uk Y₃K and intended saving is Y₃J. As a result of this, level of national income will fall to OY₂ at which ex-ante saving and ex-ante investment are once again equal and thus level of national income is in equilibrium.

To sum up, relationship between income consumption investment and saving, whereas ex-post savings and ex-post investment are always equal, ex-ante saving and ex-ante investment are equal only in equilibrium.

More Formally

In symbols, we write the consumption function as a relationship between consumption (C) and disposable income (Y^d):

where a and b are constants. Here a represents autonomous consumption and b is the marginal propensity to consume. We assume three things about a and b:

1. a > 0
2. b > 0
3. b < 1

The first assumption means that even if disposable income is zero (Y^d = 0), consumption will still be positive. The second assumption means that the marginal propensity to consume is positive. By the third assumption, the marginal propensity to consume is less that one. With 0 < b < 1, part of an extra dollar of disposable income is spent.

What happens to the remainder of the increase in disposable income? Since consumption plus saving is equal to disposable income, the increase in disposable income not consumed is saved. More generally, this link between consumption and saving (S) means that our model of consumption implies a model of saving as well.

Using

and

we can solve for S:

So −a is the level of autonomous saving and (1 − b) is the marginal propensity to save.

We can also graph the savings function. The savings function has a negative intercept because when income is zero, the household will dissave. The savings function has a positive slope because the marginal propensity to save is positive.

Economists also often look at the average propensity to consume (APC), which measures how much income goes to consumption on average. It is calculated as follows:

When disposable income increases, consumption also increases but by a smaller amount. This means that when disposable income increases, people consume a smaller fraction of their income: the average propensity to consume decreases. Using our notation, we are saying that using C = a + bY^d, so we can write

An increase in disposable income reduces the first term, relationship between income consumption investment and saving, which also reduces the APC.

The Main Use of This Tool

Before developing the Keynesian Aggregate Expenditures model, we must understand the basic macroeconomic relationships that are the components of that model. The components of aggregate expenditures in a closed economy are Consumption, Investment, and Government Spending. Because government spending is determined by a political process and is not dependent on fundamental economic variables, we will focus in this lesson on an explanation of the determinants of consumption and investment.

Section Consumption and Savings

In the simplest model we can consider, we will assume that people do one of two things with their income: they either consume it or they save it.

Income = Consumption + Savings

In this simple model, relationship between income consumption investment and saving is easy to see the relationship between income, relationship between income consumption investment and saving, consumption, and savings. If income goes up then consumption will go up and savings will go up. Consider the graph below, relationship between income consumption investment and saving, which shows Consumption as a positive function of Income:

Notice the use of the 45˚ degree line to illustrate the point at which income is equal to consumption. At that point, labeled E in our graph, savings is equal to zero. At income levels to the right of point E (like Io), savings is positive because consumption is below income, and at income levels to the left of point E (like I'), savings is negative because consumption is above income. How can savings be negative? If you thought of borrowing, you are right. In economics we call this “dissavings.” Point E is called the breakeven point because it is the point where there are no savings but there are also no dissavings. The graph below demonstrates the relationship between consumption and savings:

The Consumption Function

The Consumption Function shows the relationship between consumption and disposable income. Disposable income is that portion of your income that you have control over after you have paid your taxes. To simplify our discussion, we will assume that Consumption is a linear function of Disposable Income, just as it was graphically shown above.

C = a + b Yd

In the above equation, “a” is the intercept of the line and b is the slope. Let’s explore their meanings in economics. The intercept is the value of C when Yd is equal to zero. In other words, what would your consumption be if your disposable income were zero? Can there be consumption without income? People do this all the time. In fact, some of you students may have no income, and yet you market linked term investments still consuming because of borrowing or transfers of wealth from your parents or others to you. In any case, “a” is the amount of consumption when disposable income is zero and it is called “autonomous consumption,” or consumption that is independent of disposable income.

In the consumption function, b is called the slope. It represents the expected increase in Consumption that results from a one unit increase in Disposable Income. If Income is measured in dollars, you might ask the question, non stock investment options much would your Consumption increase if your Income were increased by one dollar?” The slope, b, would provide the answer to that question. It is the change in consumption resulting from a change in income. (Remember the idea of a slope being the rise over the run? Go back to the graph of the consumption function and satisfy yourself that the rise is the change in Consumption and the run is the change in Income, and you will see that this definition of b is consistent with the definition of a slope.) In economics, “b” is a particularly important variable because it illustrates the concept of the Marginal Propensity to Consume (MPC), which will be discussed below.

The Savings Function shows the relationship between savings and disposable income. As with consumption, we will assume that this relationship is linear:

S = e + f Yd

In this equation the intercept is e, the autonomous level of Savings. With savings, it is quite likely that “e” will be negative, which indicates that when Disposable Income is zero, Savings on average are negative. The slope of the savings function is “f,” and it represents the Marginal Propensity to Save—the increase in Savings that would be expected from any increase in Disposable Income.

Marginal Propensities to Consume and Save

The Marginal Propensity to Consume is the extra amount that people consume when they receive an extra dollar of income. If in one year your income goes up by $1, your consumption goes up by $, and you savings go up by $, then your MPC = .9 and your MPS = In general it can be said:

MPC = Change in Consumption/Change in Disposable Income = ∆C/∆Yd

MPS = Change in Savings/Change in Disposable Income = ∆S/∆Yd

It is also important to notice that: MPC + MPS = 1

Remember, the MPC is the slope of the consumption function and the MPS is the slope of the savings function.

Example

Let’s do an example using data for a hypothetical economy. The data is presented in the table below. From this data I will graph both the Consumption Function and the Savings Function and calculate the MPC and the MPS. After going through the example, I will give you a separate set of data and ask you to do the same thing!

relationship between income consumption investment and saving This image includes two graphs. The first graph depicts Yd on the X axis and C on the Y axis. The lowest value on the X axis (which is closest to the origin) is labeled 15, The following values increase by 1, as they move up the X axis. The six labeled values are 15,; 16,; 17,; 18,; 19,; and 20, The values on the Y are bonds good investment today are labeled almost midway up the axis. The lowest value (which is closest to the origin) is labeled 15, The second labeled value is just above the first and is labeled 16, The third labeled value is just above the second and is labeled 16, A dotted red line extends horizontally from each of the three values on the Y axis. The rs2022 money making red line that extends from the 15, value on the Y axis moves in a horizontal direction until it turns downward 90 degrees, which forms a right angle, and extends downward and passes through the 15, value on the X axis. The dotted red line that extends from the 16, value on the Y axis moves in a horizontal direction until it turns downward 90 degrees, which forms a right angle. The line extends downward and passes through the X axis to the wie kann ich mit bitcoin geld verdienen of the 16, value on the X axis. The dotted red line that extends from the 16, value on the Y axis moves in a horizontal direction until it turns downward 90 degrees, which forms a right angle, and extends downward and passes through the X axis to the right of the 17, value on the X-axis, relationship between income consumption investment and saving. A solid black line extends from the origin in an increasing slope at a 45 degree angle. The line is labeled 45 degrees. A second solid black line starts just before the right angle formed by the dotted red line that extends from value 15, on the Y axis. The solid black line passes through three right angles formed by the red dotted lines extending from values 15, 16, and 16, on the Y axis. The solid black line follows an increasing slope as it passes through these right angles, and the line is labeled C. The line labeled C and the line labeled 45 degrees intersect at the dotted red line's right angle that extends from the 16, value on the Y axis. This ends the description of the image's first graph. The image's second graph is located below the first. The second graph depicts S on the Y axis. A horizontal line extends from the lower half of the Y axis and is labeled Yd. The three dotted red lines from the first graph above extend down to this second graph. The dotted red line that extended from the 15, value on the first graph's Y axis extends down vertically past the second graph's horizontal Yd line. Then, it turns left 90 degrees, which is a right angle, and extends to the Y axis. The dotted red line that extended from the 16, value on the first graph's Y axis extends down vertically until it touches relationship between income consumption investment and saving second graph's Yd line. Then, the dotted red line turns left 90 degrees, which is a right angle, and extends to the second graph's Y axis. The dotted red line that extended from the 16, value on the first graph's Y axis extends down vertically and stops before touching the second graph's horizontal Yd line. Then, the dotted red line turns left 90 degrees, which is a right angle, relationship between income consumption investment and saving, and extends to the second graph's Y axis. The second graph also contains a solid black line that is labeled S and starts at a point on the Y axis that is below the horizontal Yd line. Line S then extends from the Y axis in an increasing slope that passes through the right angles of each of the three dotted red lines that turned left 90 degrees. The line labeled S and the line labeled 45 degrees intersect at the middle dotted red line's right angle, which is formed at point where it touched the Yd line.">

Notice that as you move from an income of 15, to an income of 16, consumption goes from 15, to 16, and savings goes from to 0. The MPC and MPS are therefore:

MPC = ∆C/∆Yd = / =

MPS = ∆S/∆Yd = / =

Since the Consumption Function and the Savings Function are both straight lines in this example, and since the slope of a straight line is constant between any two points on the line, it will be easy for you to verify that the MPC and the MPS are the same between any two points on the line. You can also see that that MPC + MPS =1 as was stated earlier.

Some of the Non-Income Determinants of Consumption and Savings

Notice that when we graph the Consumption Function, Consumption is measured on the vertical axis and disposable income is measured on the horizontal axis. As disposable income goes up, consumption goes up and this is shown by movement along a single consumption function. But there are other things that influence consumption besides disposable income. What if one of these non-income determinants of consumption changes? Since they are not tik tok app geld verdienen on either axis, we should note that a change in a non-income determinant of consumption will shift the entire consumption function not merely move you along a fixed consumption function. Let’s look at several of these non-income determinants of consumption and savings:

1. Wealth—In economics bitcoin investering 8 month and income are two separate variables. A simple example will illustrate the difference. Let’s say that you have a job earning $50, a year. If your great aunt Maude dies and leaves you $, in an inheritance, your income is still $50, a year, but your wealth has just gone up. The same could be said about sudden increases in the value of a piece of art that you own, the discovery of oil on your property, or increases in the value of your stock portfolio. None of these occurrences increases your income, but they all increase your wealth. An increase in wealth will increase your consumption even at the same income level, relationship between income consumption investment and saving, and can be illustrated by an upward shift in both the Consumption Function and the Savings Function. Obviously, a decrease in wealth will have the opposite effect.
2. Expectations—There are times when consumers adjust their spending, based not on their actual income but rather on their expectations of future changes in their income. Changes in expectations will cause a shift in the curve, because consumption has changed without an actual chance in income. For example, if you think your income is going to go up in the future, you may consume more today. Not that we suggest this as a wise course of action, but it has been observed that some college seniors start to spend more once they have secured a job, even though that job (and its attendant income) will not start for a month or two. This behavior would be illustrated by an upward shift in the consumption function showing that your consumption has increased even though your actual disposable income has not. Likewise, if for some reason you were pessimistic about your future income (rumors floating around the company that layoffs were eminent) you might decrease your consumption, even though your actual current income had not changed.
3. Consumer Indebtedness—Consumers adjust their consumption to levels of indebtedness as well. We observe in the aggregate economy that when indebtedness goes up, consumption falls and savings rise. There is a level of debt beyond which consumers feel uncomfortable with additional spending. Even if income has stayed the same, if too much debt accumulates, consumers will start to spend less and pay off debt. This is relationship between income consumption investment and saving by a downward shift in the Consumption Function and an upward shift in the Savings Function (remember that paying off debt is the same thing as increasing savings). The opposite is also true. At low levels of debt people will consume more and save less.

bitcoin investment strategy inc and depicts the Y axis labeled as C. A line that is not labeled extends horizontally from the lower half of the Y axis. Below this horizontal line, three lines that are parallel to each other and spaced out equally each touch a different point on the Y axis. These three lines all follow an increasing slope and extend past the horizontal line. The line that is located lowest on the Y axis is labeled S subscript 1. The middle line, which is a little higher on the Y axis, is labeled S subscript 0. The line that is located highest on the Y axis, though still lower than the horizontal line, relationship between income consumption investment and saving, is labeled S subscript 2.">

You can likely think of other factors that are unrelated to income that could shift the Consumption and Savings Functions. In general, anything that influences consumption or savings that is NOT disposable income will shift the Functions upward or downward. Any change in disposable income will move you bitcoin investing canada table the Functions.

Return to the course in I-Learn and complete the activity that corresponds with this material.

Section The Interest Rate — Investment Relationship

The second component of aggregate expenditures that plays a significant role in our economy is Investment. Remember from our lesson on National Income Accounting that investment only occurs when real capital is created. Investment is such an important part of our economy because it affects both short-run aggregate demand and long-run economic growth. Investment is a component of aggregate expenditures, so when a company buys new equipment or builds a new plant/office building, it has an immediate short-run impact on the economy. The dollars spent on the investment have the immediate impact of increasing spending in the current time period, relationship between income consumption investment and saving. But because of the nature of investment, it has a long-term impact on the economy as well. If a company buys a new machine, that machine is going to operate, continue to produce, and will have an impact on the productive capacity of the economy for years to come. This is in contrast to consumption purchases that do not have the same impact. If you buy and eat an apple today, that apple does not continue to provide consumption benefits into the future.

Expected Rate of Return

An important question in the study of investment is, “Why do firms invest?” Investment is guided by the profit motive—firms invest expecting a return on their investment. Before the investment takes place, firms only know their expected rate of return. Therefore, investment almost always involves some risk.

Consider the following scenario. Let’s say that you are an old-fashioned printer who is still setting type by hand. You know that your equipment is slow and outdated. You also know that investing in modern computerized printing presses will yield a positive return for your business, but that they will be very expensive. A new press will cost you $, and you do not have $, sitting in your drawer at home. In order to undertake the investment in new equipment, you will have to borrow the money. Let’s say you have estimated the expected rate of return on the investment in new equipment to be %. Should you borrow the money and buy the new equipment? What will influence you decision?

The key variable that will help you to decide whether the investment makes sense for you is the real interest rate that you will have to pay on the loan. If the expected rate of return in greater than the real interest rate, the investment makes sense. If it is not, then the investment will not be profitable. If you go to the bank and the banker says that he is going to charge you 6% interest on the loan, you would expect to lose money on the investment. You cannot pay 6% on the loan if you only expect to earn % on the investment. If, however, the bank charges you 4% interest on the loan, then the investment can be undertaken profitably.

The real interest rate determines the level of investment, even if you do not have to borrow the money to buy the equipment. What if you did have $, sitting in your drawer, and you had to decide whether to buy machines that would yield an expected rate of return for your company of %. If the real interest rate at the bank is 6%, you would not buy the machines. You would instead put the money in the bank and earn 6%. If the interest rate at the bank were relationship between income consumption investment and saving, you would buy the machines because they will yield a higher return than the next best alternative available to you.

The Investment Demand Curve

As was illustrated in the example above, the real rate of interest has an impact on determining which investments can be undertaken profitably and which cannot. The higher the real rate of interest, the fewer investment opportunities will be profitable. When the real rate of interest is at 8%, only those investments that have an expected rate of return higher than 8% will be undertaken. If the interest rate is 4%, all investments with an expected rate of return higher than 4% will be undertaken. There are more investments with an expected rate of return higher than 4% than there are with an expected rate of return higher than 8%, so there is more investment at a lower rather than a higher real rate of interest. This inverse relationship between the real rate of interest and the level of relationship between income consumption investment and saving is illustrated in the Investment Demand Curve shown below.

What Might Cause Shifts in the Investment Demand Curve?

As with the Consumption Function, there are factors that will shift the entire Investment Demand Curve. These are non-interest rate determinants of Investment. While there are many things that can influence the level of investment in the economy other than the real interest rate, we will discuss only three.

1. Business Taxes—The government can influence the level of investment by the tax structure they impose on businesses. When the government gives tax incentives for investing in new capital (such as allowing businesses to depreciate new capital at a faster rate, or giving tax credits for new “green” investments), this encourages additional investment at all levels of the real interest rate and shifts the Investment Demand Curve to the right. For example, in the graph below, if the real interest rate is r o, investment is at I o, the government gives tax incentives that encourage investment, then even at the same interest rate we might expect the level of investment to increase to I’, relationship between income consumption investment and saving. If the government withdraws these tax incentives, then the Investment Demand Curve shifts to the left.

why should i invest in xrp as the X axis increases. The first line is labeled I subscript 0 and originates about halfway up the Y axis. It descends through the point where the horizontal red dotted line and the vertical dotted red line closest to the origin intersect. The second solid black line is labeled I and is located farther down the X relationship between income consumption investment and saving than line I subscript 0. As it descends, it passes through the point where the horizontal red dotted line and the vertical dotted red line in the middle intersect. The third solid black line is labeled I superscript 1 and is located farther down the X axis than line I. As it descends, it passes through the point where the horizontal red dotted line and the vertical dotted red line farthest from the origin intersect, relationship between income consumption investment and saving. Between the first and second solid black lines, there is an arrow pointing to the left that is labeled Decrease in I Demand. Between the second and third solid black lines, there is an arrow pointing to the right labeled Increase in I demand.">

2. Changes in Technology—A business will be more likely to increase investment in an industry where relationship between income consumption investment and saving is changing than in an industry with a more fixed technology. Businesses recognize the need to keep up with competitors’ utilization of modern technology. At any given level of the real interest rate you would expect Investment Demand to be higher the more technology is advancing.
3. Stock of Capital Goods on Hand—Businesses that already have a significant stock of capital on hand are less likely to invest in additional capital. For instance, a company that has excess office space or idle plants is not as likely to invest in additional capital as a business that is operating at or beyond capacity. At any given level of the real interest rate, you relationship between income consumption investment and saving expect more investment by a firm that is short on capital goods than by a firm that has an adequate stock of capital on hand.

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Marginal Propensity to Consume vs. Marginal Propensity to Save: An Overview

Historically, consumer demand and consumption have helped drive the U.S. economy. When American consumers have a greater amount of extra income, they might spend a portion of it, thereby spurring growth in the economy. Consumers might also save a portion of their extra income.

These tendencies aren't mere observations but are the basis for the marginal propensity to save (MPS) and the marginal propensity to consume (MPC).

Marginal Propensity to Save

The marginal propensity to save (MPS) is the portion of each extra dollar of a household’s income that's saved. The MPS indicates what the overall household sector does with extra income—specifically, the percent of extra income that is saved.

As saving is a complement of consumption, the MPS reflects key aspects of a household’s activity and its consumption habits. It is expressed as a percentage. For example, if the marginal propensity to save is 10%, it means that out of each additional dollar earned, 10 cents is saved.

The marginal propensity to save is calculated by dividing the change in savings by the change in income. For example, if consumers saved 20 cents for every $1 increase in income, the MPS would be (/$1) or 20%.

The MPS reflects the savings amount or leakage of income from the economy. Leakage is the portion of income that's not put back into the economy through purchases of goods and services. The higher the income for an individual, the higher the MPS as the ability to satisfy needs increases with income. In other words, each additional dollar is less likely to be spent as an individual becomes wealthier. Studying MPS helps economists determine how wage growth might influence savings.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) is the flip side of MPS. MPC helps to quantify the relationship between income and consumption. MPC is the portion of each extra dollar of a household’s income that is consumed or spent. For example, if the marginal propensity to consume is 45%, out of each additional dollar earned, 45 cents is spent.

Economic theory tends to support that as income increases, so too does spending and consumption. MPC measures that relationship to determine how much spending increases for each dollar of additional income. MPC is important because it varies at different income levels and is the lowest for higher-income households.

The marginal propensity to consume is calculated by dividing the change in spending by the change in income. For example, if consumers spent 80 cents for every $1 increase in income, the MPC would be (/$1) or 80%.

For example, imagine that Congress wants to enact a tax rebate to spur economic activity through consumer spending. MPC can be used to assess the likelihood of which household's, based on their income, would have the greatest likelihood or propensity to spend the tax cut, rather than save it.

The MPC percentage can also be used by economists to determine how much of each $1 in tax rebates will be spent. In doing so, they can adjust the total size of the rebate program to achieve the desired spending per household.

The MPC is also vital to the study of Keynesian economics, which is the result of economist John Maynard Keynes. Keynesian economics was developed during the s in an attempt to understand the Great Depression. Keynes advocated for increased government expenditures and lower taxes to stimulate demand and pull the global economy out of the depression. The extent to which stimulus adds to economic growth is called the Keynesian multiplier.

The MPC, like the MPS, affects the multiplier process and affects the magnitude of expenditures and tax multipliers. Ultimately, both MPS and MPC are used to discuss how a household utilizes its surplus income, whether that income is saved or spent. Consumer behavior concerning saving or spending has a very significant impact on the economy as a whole.

Before developing the Keynesian Aggregate Expenditures model, we must understand the basic macroeconomic relationships that are the components of that model. The components of aggregate expenditures in a closed economy are Consumption, Investment, and Government Spending. Because government spending is determined by a political process and is not dependent on fundamental economic variables, we will focus in this lesson on an explanation of the determinants of consumption and investment.

Section Consumption and Savings

In the simplest model we can consider, we will assume that people do one of two things with their income: they either consume it or they save it.

Income = Consumption + Savings

In this simple model, it is easy to see the relationship between income, consumption, and savings. If income goes up then consumption will go up and savings will go up. Consider the graph below, which shows Consumption as a positive function of Income:

Notice the use of the 45˚ degree line to illustrate the point at which income is equal to consumption. At that point, labeled E in our graph, savings is equal to zero. At income levels to the right of point E (like Io), savings is positive because consumption is below income, and at income levels to the left of point E (like I'), savings is negative because consumption is above income. How can savings be negative? If you thought of borrowing, you are right. In economics we call this “dissavings.” Point E is called the breakeven point because it is the point where there are no savings but there are also no dissavings. The graph below demonstrates the relationship between consumption and savings:

The Consumption Function

The Consumption Function shows the relationship between consumption and disposable income. Disposable income is that portion of your income that you have control over after you have paid your taxes. To simplify our discussion, we will assume that Consumption is a linear function of Disposable Income, just as it was graphically shown above.

C = a + b Yd

In the above equation, “a” is the intercept of the line and b is the slope. Let’s explore their meanings in economics. The intercept is the value of C when Yd is equal to zero. In other words, what would your consumption be if your disposable income were zero? Can there be consumption without income? People do this all the time. In fact, some of you students may have no income, and yet you are still consuming because of borrowing or transfers of wealth from your parents or others to you. In any case, “a” is the amount of consumption when disposable income is zero and it is called “autonomous consumption,” or consumption that is independent of disposable income.

In the consumption function, b is called the slope. It represents the expected increase in Consumption that results from a one unit increase in Disposable Income. If Income is measured in dollars, you might ask the question, “How much would your Consumption increase if your Income were increased by one dollar?” The slope, b, would provide the answer to that question. It is the change in consumption resulting from a change in income. (Remember the idea of a slope being the rise over the run? Go back to the graph of the consumption function and satisfy yourself that the rise is the change in Consumption and the run is the change in Income, and you will see that this definition of b is consistent with the definition of a slope.) In economics, “b” is a particularly important variable because it illustrates the concept of the Marginal Propensity to Consume (MPC), which will be discussed below.

The Savings Function shows the relationship between savings and disposable income. As with consumption, we will assume that this relationship is linear:

S = e + f Yd

In this equation the intercept is e, the autonomous level of Savings. With savings, it is quite likely that “e” will be negative, which indicates that when Disposable Income is zero, Savings on average are negative. The slope of the savings function is “f,” and it represents the Marginal Propensity to Save—the increase in Savings that would be expected from any increase in Disposable Income.

Marginal Propensities to Consume and Save

The Marginal Propensity to Consume is the extra amount that people consume when they receive an extra dollar of income. If in one year your income goes up by $1,, your consumption goes up by $, and you savings go up by $, then your MPC = .9 and your MPS = In general it can be said:

MPC = Change in Consumption/Change in Disposable Income = ∆C/∆Yd

MPS = Change in Savings/Change in Disposable Income = ∆S/∆Yd

It is also important to notice that: MPC + MPS = 1

Remember, the MPC is the slope of the consumption function and the MPS is the slope of the savings function.

Example

Let’s do an example using data for a hypothetical economy. The data is presented in the table below. From this data I will graph both the Consumption Function and the Savings Function and calculate the MPC and the MPS. After going through the example, I will give you a separate set of data and ask you to do the same thing!

Notice that as you move from an income of 15, to an income of 16,, consumption goes from 15, to 16, and savings goes from to 0. The MPC and MPS are therefore:

MPC = ∆C/∆Yd = / =

MPS = ∆S/∆Yd = / =

Since the Consumption Function and the Savings Function are both straight lines in this example, and since the slope of a straight line is constant between any two points on the line, it will be easy for you to verify that the MPC and the MPS are the same between any two points on the line. You can also see that that MPC + MPS =1 as was stated earlier.

Some of the Non-Income Determinants of Consumption and Savings

Notice that when we graph the Consumption Function, Consumption is measured on the vertical axis and disposable income is measured on the horizontal axis. As disposable income goes up, consumption goes up and this is shown by movement along a single consumption function. But there are other things that influence consumption besides disposable income. What if one of these non-income determinants of consumption changes? Since they are not measured on either axis, we should note that a change in a non-income determinant of consumption will shift the entire consumption function not merely move you along a fixed consumption function. Let’s look at several of these non-income determinants of consumption and savings:

1. Wealth—In economics wealth and income are two separate variables. A simple example will illustrate the difference. Let’s say that you have a job earning $50, a year. If your great aunt Maude dies and leaves you $, in an inheritance, your income is still $50, a year, but your wealth has just gone up. The same could be said about sudden increases in the value of a piece of art that you own, the discovery of oil on your property, or increases in the value of your stock portfolio. None of these occurrences increases your income, but they all increase your wealth. An increase in wealth will increase your consumption even at the same income level, and can be illustrated by an upward shift in both the Consumption Function and the Savings Function. Obviously, a decrease in wealth will have the opposite effect.
2. Expectations—There are times when consumers adjust their spending, based not on their actual income but rather on their expectations of future changes in their income. Changes in expectations will cause a shift in the curve, because consumption has changed without an actual chance in income. For example, if you think your income is going to go up in the future, you may consume more today. Not that we suggest this as a wise course of action, but it has been observed that some college seniors start to spend more once they have secured a job, even though that job (and its attendant income) will not start for a month or two. This behavior would be illustrated by an upward shift in the consumption function showing that your consumption has increased even though your actual disposable income has not. Likewise, if for some reason you were pessimistic about your future income (rumors floating around the company that layoffs were eminent) you might decrease your consumption, even though your actual current income had not changed.
3. Consumer Indebtedness—Consumers adjust their consumption to levels of indebtedness as well. We observe in the aggregate economy that when indebtedness goes up, consumption falls and savings rise. There is a level of debt beyond which consumers feel uncomfortable with additional spending. Even if income has stayed the same, if too much debt accumulates, consumers will start to spend less and pay off debt. This is illustrated by a downward shift in the Consumption Function and an upward shift in the Savings Function (remember that paying off debt is the same thing as increasing savings). The opposite is also true. At low levels of debt people will consume more and save less.

You can likely think of other factors that are unrelated to income that could shift the Consumption and Savings Functions. In general, anything that influences consumption or savings that is NOT disposable income will shift the Functions upward or downward. Any change in disposable income will move you along the Functions.

Return to the course in I-Learn and complete the activity that corresponds with this material.

Section The Interest Rate — Investment Relationship

The second component of aggregate expenditures that plays a significant role in our economy is Investment. Remember from our lesson on National Income Accounting that investment only occurs when real capital is created. Investment is such an important part of our economy because it affects both short-run aggregate demand and long-run economic growth. Investment is a component of aggregate expenditures, so when a company buys new equipment or builds a new plant/office building, it has an immediate short-run impact on the economy. The dollars spent on the investment have the immediate impact of increasing spending in the current time period. But because of the nature of investment, it has a long-term impact on the economy as well. If a company buys a new machine, that machine is going to operate, continue to produce, and will have an impact on the productive capacity of the economy for years to come. This is in contrast to consumption purchases that do not have the same impact. If you buy and eat an apple today, that apple does not continue to provide consumption benefits into the future.

Expected Rate of Return

An important question in the study of investment is, “Why do firms invest?” Investment is guided by the profit motive—firms invest expecting a return on their investment. Before the investment takes place, firms only know their expected rate of return. Therefore, investment almost always involves some risk.

Consider the following scenario. Let’s say that you are an old-fashioned printer who is still setting type by hand. You know that your equipment is slow and outdated. You also know that investing in modern computerized printing presses will yield a positive return for your business, but that they will be very expensive. A new press will cost you $, and you do not have $, sitting in your drawer at home. In order to undertake the investment in new equipment, you will have to borrow the money. Let’s say you have estimated the expected rate of return on the investment in new equipment to be %. Should you borrow the money and buy the new equipment? What will influence you decision?

The key variable that will help you to decide whether the investment makes sense for you is the real interest rate that you will have to pay on the loan. If the expected rate of return in greater than the real interest rate, the investment makes sense. If it is not, then the investment will not be profitable. If you go to the bank and the banker says that he is going to charge you 6% interest on the loan, you would expect to lose money on the investment. You cannot pay 6% on the loan if you only expect to earn % on the investment. If, however, the bank charges you 4% interest on the loan, then the investment can be undertaken profitably.

The real interest rate determines the level of investment, even if you do not have to borrow the money to buy the equipment. What if you did have $, sitting in your drawer, and you had to decide whether to buy machines that would yield an expected rate of return for your company of %. If the real interest rate at the bank is 6%, you would not buy the machines. You would instead put the money in the bank and earn 6%. If the interest rate at the bank were 4%, you would buy the machines because they will yield a higher return than the next best alternative available to you.

The Investment Demand Curve

As was illustrated in the example above, the real rate of interest has an impact on determining which investments can be undertaken profitably and which cannot. The higher the real rate of interest, the fewer investment opportunities will be profitable. When the real rate of interest is at 8%, only those investments that have an expected rate of return higher than 8% will be undertaken. If the interest rate is 4%, all investments with an expected rate of return higher than 4% will be undertaken. There are more investments with an expected rate of return higher than 4% than there are with an expected rate of return higher than 8%, so there is more investment at a lower rather than a higher real rate of interest. This inverse relationship between the real rate of interest and the level of investment is illustrated in the Investment Demand Curve shown below.

What Might Cause Shifts in the Investment Demand Curve?

As with the Consumption Function, there are factors that will shift the entire Investment Demand Curve. These are non-interest rate determinants of Investment. While there are many things that can influence the level of investment in the economy other than the real interest rate, we will discuss only three.

1. Business Taxes—The government can influence the level of investment by the tax structure they impose on businesses. When the government gives tax incentives for investing in new capital (such as allowing businesses to depreciate new capital at a faster rate, or giving tax credits for new “green” investments), this encourages additional investment at all levels of the real interest rate and shifts the Investment Demand Curve to the right. For example, in the graph below, if the real interest rate is r o, investment is at I o, the government gives tax incentives that encourage investment, then even at the same interest rate we might expect the level of investment to increase to I’. If the government withdraws these tax incentives, then the Investment Demand Curve shifts to the left.



2. Changes in Technology—A business will be more likely to increase investment in an industry where technology is changing than in an industry with a more fixed technology. Businesses recognize the need to keep up with competitors’ utilization of modern technology. At any given level of the real interest rate you would expect Investment Demand to be higher the more technology is advancing.
3. Stock of Capital Goods on Hand—Businesses that already have a significant stock of capital on hand are less likely to invest in additional capital. For instance, a company that has excess office space or idle plants is not as likely to invest in additional capital as a business that is operating at or beyond capacity. At any given level of the real interest rate, you would expect more investment by a firm that is short on capital goods than by a firm that has an adequate stock of capital on hand.

The Relationship between Saving and Investment!

An important controversy in macroeconomics relates to the relationship between saving and investment. Many economists before J.M. Keynes were generally of the view that saving and investment are generally not equal; they are equal only under condition of equilibrium. Besides, they thought that equality between saving and investment is brought about by changes in the rate of interest. Keynes in his famous work &#;General Theory of Employment, Interest and Money&#; put forward the view that saving and investment are always equal.

This gave rise to a severe controversy in economics as to whether saving and investment are always equal or they are generally unequal. This controversy has now been resolved, and there is general agree­ment among the economists about the correct relationship between saving and investment.

Mod­ern economists use the concepts of saving and investment in two different senses. In one sense, saving and investment are always equal, equilibrium or no equilibrium. In the second sense, saving and investment are equal only in equilibrium; they are unequal under conditions of disequilibrium. We shall explain below in detail the relationship between saving and investment in these two different senses.

When in a certain year there is net addition to the stock of capital, investment is said to have taken place. It is worth mentioning here that by investment we do not mean the stock of capital but the net addition to the stock of capital i.e., investment is a flow concept. Of course, addition to the stock of capital is made through the flow of investment. In every year stock of capital expands through net investment.

On the other hand, by saving we mean the part of the income which has not been spent on consumer goods and services. In other words, saving is the difference between income and consumption expenditure. It is worth noting that in consumption expenditure all types of expenditure are not included. If an individual spends a part of his income on providing irrigation facilities, on buying tools and machinery, then that expenditure is not the consumption expenditure, it is in fact an investment expenditure.

In order to obtain the saving, we have only to deduct the consumption expenditure from income and not the investment expenditure. When an individual makes investment expenditure he is deemed to spend his saved income on investment. For instance, if a farmer&#;s annual income is Rs. 10, and he spends Rs. 6, on consumer goods and services and spends Rs. 1, on the construction of a well for his fields, and another Rs. 1, on building a drainage system for his fields and providing fencing, then his saving would be 10 &#; 6 = Rs. 4 thousands.

The expenditure of Rs. 2, on well, drainage and fencing will be included in the saving and will not constitute the consumption expenditure. If Y represents the national income of a country and C the total consumption, then the saving of the country will be equal to Y &#; C. Thus,

S = Y &#; C

Ex-post Savings and Ex-post Investment are always equal:

Pre-Keynesian economists were of the view that savings and investment are generally not equal. This is firstly because saving and investment are made by two different classes of people. While investment is undertaken by entrepreneurial class of the society, saving is done by the general public. Secondly, saving and investment depend upon different factors and are made for different purposes and motives.

Therefore, it is not inevitable that savings and investment of a society must always be equal. Besides, some pre-Keynesian economists pointed out that invest­ment expenditure is also undertaken by borrowing money from the banks which create new credit for this purpose.

It was thus pointed out that more amount of investment than savings is possible because excess of investment over savings is financed by new bank credit. But Keynes expressed a totally opposite view that saving and investment are always equal. The sense in which savings and investment are always equal refers to the actual savings and actual investment made in the economy during a year.

They are also called ex-post saving and ex-post investment. If we have to calculate that during the year , how much actual savings and investment have been made in India, we will have to deduct the total consumption expenditure made by the citizens of India during that year from the national income.

Likewise, the real investment during the year of the Indian economy will be obtained by summing up the investments actually made by the Indian people during that year. In fact, national income estimates of savings and investment are made in this actual or ex-post sense.

The second sense in which saving and investment words are used is that in a certain year how much saving or how much investment people of the country desire or intend to do. There­fore, saving and investment in this sense are known as desired, intended or planned savings and investment. They are also called ex-ante saving and ex-ante investment.

Keynes in his book, &#;General Theory of Employment, Interest and Money&#; showed that in spite of the fact that saving and investment are done by two different classes of people and also for different purposes and motives, actual saving and actual investment are always equal.

Thus, he used the word saving and investment in the ex-post or actual sense and proved the equality between saving and investment in the following way:

Income of a country is earned in two ways:

(1) By producing and selling consumer goods and services, and

(2) By producing and selling capital goods.

That is, national income of a country is composed of the value of consumer goods and services and the value of capital goods.

This can be expressed in the form of the following equation:

National Income = Consumption + Investment

or

Y = C + I

where Y stands for national income, C for consumption and I for investment.

The above equation represents the production or earning side of the national income. The second aspect of national income is the expenditure side. The total national income can be fully consumed but generally it does not happen so. In actual practice, a part of the total income is spent on consumption and the remaining part is saved.

From this we get the following equation:

National Income = Consumption + Saving

Or

Y = C + S

where Y stands for national income, C for consumption and S for saving.

In the above two equations (i) and (ii) it is clear that national income is equal to the sum of consumption and investment and also equal to the sum of consumption and saving.

From this it follows that:

Consumption + Saving = Consumption + Investment

C + S = C + I

In equation (iii) above, since C occurs on both sides of the equation, we get:

Saving = Investment

or

S = I

From the foregoing analysis, it follows that saving and investment are defined in such a ay that they are necessarily equal to each other. In equation (i) investment is that part of national income which is obtained from the production of goods other than those consumed and equation (ii) saving is that part of national income which is not spent on consumption.

Hence the actual or ex-post sense, saving and investment by definition are equal. It is worth mentioning that in macroeconomics, saving and investment do not refer to the saving and investment by an individual; they refer to the saving and investment of the whole community or economy. Saving and investment by an individual can differ but in the ex-post sense, the saving of the whole country must always be equal to the investment.

Now the question arises, why ex-post saving and ex-post investment are always equal. For instance, when more investment is undertaken by the entrepreneurs how actual saving becomes equal to this larger investment and if the saving falls how investment will become equal to smaller savings. In this connection it is worth mentioning that modern economists, as did Keynes, include the addition to the inventories of consumer goods in investment.

Now, when saving increases, it implies that consumption will be less. The decline in consumption would result in the addition to the inventories of consumer goods with the shopkeepers and manufacturers, which were not planned or intended by them. This addition to inventories, though unintended, will raise the level of actual investment.

Thus unintended increase in inventories will raise the level of investment and in this way investment will increase to become equal to the greater saving. On the other hand, if in any year saving declines, it will result in the unplanned decline in the inventories of consumer goods with the traders and manufacturers. This unintended decline in inventories will mean the fall in actual investment. In this way, investment will decline to become equal to the lower savings.

Ex-ante saving and Ex-ante Investment are Equal only in Equilibrium:

As said above, in the desired, planned or ex-ante sense, saving and investment can differ. In fact planned or ex-ante saving and investment are generally not equal to each other. This is due to the fact that the persons or classes who save are different from those who invest.

Savings are done by general public for various objectives and purposes. On the other hand, investment is made by the entrepreneurial class in the community and is generally governed by marginal efficiency of capital on the one hand and rate of interest on the other hand.

Therefore, savings and investment in planned or ex-ante sense generally differ from each other. But through the mechanism of change in the income level, there is tendency for ex-ante saving and ex-ante investment to become equal.

When in a year planned investment is larger than planned saving, the level of income rises. At a higher level of income, more is saved and therefore intended saving becomes equal to intended investment. On the other hand, when planned saving is greater than planned investment in a period, the level of income will fall.

At a lower level of income, less will be saved and therefore planned saving will become equal to planned investment. We thus see that planned or ex-ante saving and planned or ex-ante investment are brought to equality through changes in the level of income. When ex-ante saving and ex-ante invest­ment are equal, level of income is in equilibrium i.e., it has no tendency to rise or fall.

It is thus clear that whereas realised or ex-post saving is equal to realised or ex-post investment, intended, planned or ex-ante saving and investment may differ; intended or ex-ante saving and investment have only a ten­dency to be equal and are equal only at the equi­librium level of income.

That the planned or intended saving is equal to intended investment only at the equilibrium level of income can be easily understood from Fig. In this figure, national income is measured along the X-axis while saving and investment are measured along the Y-axis.

SS is the saving curve which slopes upward indicating thereby that with the rise in income, saving also increases. II is the investment curve. Investment curve II is drawn as horizontal straight line because, following Keynes, it has been assumed that investment is independent of the level of income i.e., it depends upon factors other than the current level of income.

It will be seen from the Fig. that saving and investment curves intersect at point E. Therefore, OY is the equilibrium level of income. If the level of income is OY₁, the intended investment is Y₁H whereas the intended saving is Y₁L. It is thus clear that at OY₁ level of income, intended investment is greater than intended saving.

As a result of this, level of income will rise and at higher levels of income more will be saved. It will be seen that with the rise in income to OY₂, saving rises and becomes equal to investment. On the other hand, if in any period, level of income is OY₃ intended investment is Y₃K and intended saving is Y₃J. As a result of this, level of national income will fall to OY₂ at which ex-ante saving and ex-ante investment are once again equal and thus level of national income is in equilibrium.

To sum up, whereas ex-post savings and ex-post investment are always equal, ex-ante saving and ex-ante investment are equal only in equilibrium.

More Formally

In symbols, we write the consumption function as a relationship between consumption (C) and disposable income (Y^d):

where a and b are constants. Here a represents autonomous consumption and b is the marginal propensity to consume. We assume three things about a and b:

1. a > 0
2. b > 0
3. b < 1

The first assumption means that even if disposable income is zero (Y^d = 0), consumption will still be positive. The second assumption means that the marginal propensity to consume is positive. By the third assumption, the marginal propensity to consume is less that one. With 0 < b < 1, part of an extra dollar of disposable income is spent.

What happens to the remainder of the increase in disposable income? Since consumption plus saving is equal to disposable income, the increase in disposable income not consumed is saved. More generally, this link between consumption and saving (S) means that our model of consumption implies a model of saving as well.

Using

and

we can solve for S:

So −a is the level of autonomous saving and (1 − b) is the marginal propensity to save.

We can also graph the savings function. The savings function has a negative intercept because when income is zero, the household will dissave. The savings function has a positive slope because the marginal propensity to save is positive.

Economists also often look at the average propensity to consume (APC), which measures how much income goes to consumption on average. It is calculated as follows:

When disposable income increases, consumption also increases but by a smaller amount. This means that when disposable income increases, people consume a smaller fraction of their income: the average propensity to consume decreases. Using our notation, we are saying that using C = a + bY^d, so we can write

An increase in disposable income reduces the first term, which also reduces the APC.

The Main Use of This Tool