ECON102: Principles of Macroeconomics (2021.A.01)

Investment is influenced by the level of income, by the expected course of future income, by anticipated consumption, and by the flow of savings. For example, a fall in savings will mean a cut in the funds available for investment, thus restricting investment.

Classics on Saving and Investment.

The classical economists argued that interest rates would fall due to the excess supply of "loanable funds". This was the original Keynesian position, too, in which he followed both Malthus and John A. Hobson. The first diagram, adapted from the only graph in The General Theory, shows this process. Assume that fixed investment in capital goods falls from "old I" to "new I" (step a). Second (step b), the resulting excess of saving causes interest-rate cuts, abolishing the excess supply: so again we have saving (S) equal to investment. The interest-rate fall prevents the drop in production and employment.

Later on, however, excessive savings became Keynes' preoccupation; he believed that excessive saving had been Britain's and the United States' principal problem in the late 1920s, encouraging recession or even depression, so that only a demand-side kick could re-stimulate the economy.

The graph below summarizes his argument, assuming again that fixed investment falls (step A). First, saving does not fall much as interest rates fall, since the income and substitution effects of falling rates go in conflicting directions. Second, since planned fixed investment in plant and equipment is mostly based on long-term expectations of future profitability, that spending does not rise much as interest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity of both demand and supply, a large interest-rate fall is needed to close the saving/investment gap. As drawn, this requires a negative interest rate at equilibrium (where the new I line would intersect the old S line).

Keynes on Saving and Investment.

Keynes, as it follows from the graph, felt that especially in a depression, a reduction in an interest rate will have little effect on savings. If people prefer liquidity, savings will not be reduced no matter how the interest was. As a recession undermines the business incentive to engage in fixed investment. With falling incomes and demand for products, the desired demand for factories and equipment (not to mention housing) will fall. This accelerator effect would shift the I line to the left again, a change not shown in the diagram above. This recreates the problem of excessive saving and encourages the recession to continue. However, some Keynesians now appear to accept the importance of savings, even excessive savings as it always returns to the investment (even in the next time period) for economic growth.