saving and investment graph macroeconomics for dummies

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Saving and investment graph macroeconomics for dummies british gas dividend reinvestment

Saving and investment graph macroeconomics for dummies

The LM curve depicts the set of all levels of income GDP and interest rates at which money supply equals money liquidity demand. The LM curve slopes upward because higher levels of income GDP induce increased demand to hold money balances for transactions, which requires a higher interest rate to keep money supply and liquidity demand in equilibrium. The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when money markets and the real economy are in balance.

Multiple scenarios or points in time may be represented by adding additional IS and LM curves. In some versions of the graph, curves display limited convexity or concavity. Shifts in the position and shape of the IS and LM curves, representing changing preferences for liquidity, investment, and consumption, alter the equilibrium levels of income and interest rates.

Many economists, including many Keynesians, object to the IS-LM model for its simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted that the model's flaws were fatal, and it was probably best used as "a classroom gadget, to be superseded, later on, by something better. The model is a limited policy tool, as it cannot explain how tax or spending policies should be formulated with any specificity.

This significantly limits its functional appeal. It has very little to say about inflation, rational expectations, or international markets, although later models do attempt to incorporate these ideas. The model also ignores the formation of capital and labor productivity. John Hicks. Keynes and the 'Classics'; A Suggested Interpretation. Accessed Aug. John Maynard Keynes. Steven Kates. Edward Elgar, Monetary Policy. Your Money. Personal Finance. Your Practice. Popular Courses.

Economics Macroeconomics. Key Takeaways The IS-LM model describes how aggregate markets for real goods and financial markets interact to balance the rate of interest and total output in the macroeconomy. IS-LM stands for "investment savings-liquidity preference-money supply. IS-LM can be used to describe how changes in market preferences alter the equilibrium levels of gross domestic product GDP and market interest rates.

As with consumption, we will assume that this relationship is linear:. In this equation the intercept is e, the autonomous level of Savings. The Marginal Propensity to Consume is the extra amount that people consume when they receive an extra dollar of income. In general it can be said:. The data is presented in the table below. 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.

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. Graph the Consumption Function and the Savings Function for the data provided in the table below. 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.

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. 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.

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.

Before the investment takes place, firms only know their expected rate of return. Therefore, investment almost always involves some risk. Consider the following scenario. 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.

In order to undertake the investment in new equipment, you will have to borrow the money. 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.

The real interest rate determines the level of investment, even if you do not have to borrow the money to buy the equipment.

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Funds from govt. Funds from private saving. Here, the government surplus means that investment is greater than saving. In the case of a government deficit, the demand curve will shift to the right. Investment will be less than saving.

Table shows how. Figure Equilibrium interest rate with Deficit. Private saving covering deficit. Private saving used for invest-ment. Here, the government deficit means that saving is greater than investment. Some people read them to say that when the government runs a deficit it "crowds out" investment, reducing the supply of saving for investment, and that, when it runs a surplus, it supplements private saving, making more available for investment. The truth is more complicated.

Wait until the next lecture. In discussing the loans market, we have treated it as solely a domestic one. Nevertheless, there is an important international aspect to this market. We come back to this subject when we turn to the international sector. Because there is an international capital market with an international interest rate, any difference between domestic demand and supply of loans is absorbed into the international market. If American demand for loans exceeds American Supply, we borrow the difference abroad; if American Supply exceeds American Demand, we lend abroad.

International Borrowing. Domestic Demand for Loans. Domestic Supply of Loans. World Demand for Loans. World Supply of Loans. Figure shows the equilibrium in this case, in both the domestic and the world market for funds. To make the graph simple, this graph only talks about the total demand for funds. As you can see from this graph, at the world interest rate — the rate that equates the world demand and supply of funds — there is a gap between the quantity of loans supplied and demanded domestically.

International borrowing makes up this gap. There is a lot of truth in this graph, but it is probably a little too simplistic. Americans probably face an upward sloping international supply curve of loans. The more we borrow, the higher the interest rate we pay. The more we lend abroad, the lower the interest rate we receive. There is some preference to by everyone to lend domestically, where you know the market best.

Thus, if Americans are borrowing abroad, they are probably paying a premium above the world interest rate. Do changes in a country's supply and demand for loans affect the world rate? It depends. For a country such as Bolivia, the affect is probably negligible. Figure shows what would happen with an increase in the Bolivia's demand for loans. There would be no change in the world rate, and Bolivia would simply borrow more from abroad.

Bolivian Demand for Loans. Bolivian Supply of Loans. When Bolivia's demand for loans increases, there is no effect on the world interest rate. There is simply an increase D B in the amount being borrowed on international markets.. A more precise statement would be that the change is negligible.. On the other hand, the United States is a major player in the world economy. When we increase our demand for loans, world rates will adjust. Figure shows what would happen in this case. American Demand for Loans.

American Supply of Loans. When the American demand for loans increases, the world demand shifts to the right. The world interest rate rises to R w. There is both an increase in loans demanded and supplied in the United States.

International borrowing may or may not increase. In fact, we will go beyond Crusoe and include government borrowing and international trade in our discussion. This condition is sometimes referred to as equilibrium in the goods market. That is, the demand and supply of GDP are equal. In fact, what we have ended up with is Figure , showing equilibrium in the loans market.

Rest assured that these are related. Whenever the loans market is in equilibrium, so too is the goods market. That is the total demand for goods and services will equal the supply of good and services. To see why, note that equilibrium in the loans market requires that. Obviously, the government deficit is equal to the difference between government purchases G and taxes T , so we can rewrite our equation as.

As to foreign saving, the only way foreigners can make investments in a country is by exporting more to that country than they import. Thus we know that. It is traditional to multiply this equation through by —1 and rewrite it as. When we discuss the international sector, the left hand side of this equation represents the balance in the capital account.

That is, the amount we borrowed or if it is negative the amount we lent abroad. The right hand side represents the balance in the current account, which is the extent to which our exports exceeded our imports. In fact that is why we multiply through by —1. The left hand side is then the amount we lend abroad or, if negative, the amount we borrow abroad; the right hand side is the amount by which exports exceed imports. Finally, we know domestic savings is defined as the difference between after tax income Y-T and consumption, or.

In short, when the demand and supply of loans are in balance so too is the goods market. A numerical example may help make this issue clear. Table gives some hypothetical data on GDP. Gross Domestic Product. Government Purchases of Goods and Services. We cannot stop there, for there is another problem. Something has to give. Think about the patrons of Miller's Pizzeria consuming pizzas while the Pizzeria bakes They would have to import. So too it is with the country. It is no accident that the amount of net imports is exactly equal to the net capital flows.

They must be equal. That is,. Essentially, having an international economy provides a third source of funds for the loan market and one that can easily be positive or negative. We will return to this equation later in the course when we discuss the importance of capital flows.

This gets controversial. We turn to this subject in depth later. For the moment, think of the following situation:. You are the manager of Miller's Pizzeria. Customers are ordering pizzas, when you can only make Would you not be better off importing 15 additional pizzas perhaps discretely removing the Dominos boxes and making the profit on 15 extra sales than refusing to "live beyond your means? This is a good place to straighten out a major source of confusion between real and nominal interest rates.

Most of the interest rates that you see discussed in places like the Wall Street Journal or TV newscasts are nominal interest rates that give the return in terms of the pictures of George Washington. That is, you lend me pictures of George and I will return you say pictures. The interest rates that banks quote for a loan or that you pay on your credit card are nominal interest rates. The distinction between real and nominal interest rates is vital. Indeed, one study suggested that the distinction between real and nominal rates is the key point for any macroeconomics course to get across.

Economists talk about real interest rates, which give the return in terms of purchasing power. In other words, you lend me enough to purchase pizzas and I will return you say enough to purchase pizzas. An example will illustrate the relationship between the two. That is, you promised to give me back pictures of George.

My real return is measured in terms of the percent increase decrease in the number of pizza slices I can purchase. Amount paid back. Increase in price of a slice of pizza. Price of a pizza slice. Number of pizza slices I can buy. Percent increase. There is a simple relation between the nominal interest rate here, six percent and the realized rate. As an approximation, subtract the inflation rate from the nominal interest rate.

If the inflation rate is negative, remember how to subtract a negative number. When you do, you will get the real return. Or actually, you will get very close to it. There is a minor adjustment that you must apply to get the exact result, but it is not worth going into. We summarize these relations between real and nominal returns with a simple relation, the so-called Fisher Equation. We can also use the equation to set future interest rates.

The terms for lending depend on several factors:. Your credit worthiness. Tax considerations. My impatience motive. Inflationary Expectations. We cross out the first two, because they will distract us here. Suppose that I would want a reward of another three pizza slices for postponing consumption.

I now want to know much inflation will occur over the next year. If I expect an inflation rate of. The cost of a slice of pizza a year hence will be. And the cost of 53 pizza slices will be. The implied nominal interest rate is. In short, we can use the Fisher equation to set a nominal rate to get our desired real rate.

We get another basic rule. All Economists and All Economics students are required to learn and use the following relations between real and nominal interest rates. It would be nice if all questions in economics were this simple. Where saving and investment are concerned, always use the real rate. You want to know how many extra pizza slices you will get from dieting today. Here, you want to know how many slices of pizza you must sell in the years to come to pay back your investment.

We will turn to this issue later. If this story does not make it this semester, they will certainly carry one or more stories about how the Federal Reserve System should change interest rates, or might change interest rates, or recently changed interest rates. As this lecture makes clear, the fundamental mechanism for setting interest rates is the process of equating Saving and Investment, with appropriate adjustment for Government deficits and the international sector.

The Federal Reserve System does not set interest rates. When we talk about the money supply, we will learn that the Federal Reserve System has limited control over one interest rate, called the Federal Funds Rate. However, we are getting ahead of our story. Most public discussions of interest rates focus on nominal interest rates, inasmuch as most loans are set in nominal terms. However, there are some government bonds which pay interest in real terms.

These securities pay interest, but the redemption value is adjusted up for changes in the inflation rate. That is, though they pay off in pictures of George Washington, the number of pictures of George will be increased to keep the number of slices of pizza it purchases constant.

The prices are given daily in Financial Newspapers. Look, for instance at the first security. It pays a promised rate of 3. Because it sells at a small discount, the effective yield to maturity is 4. Accrued Principal. Because these securities are in real terms, the interest rates are the real interest rate. Thus, if you want to know the real rate between now and July it is 4. The same issue of the Wall Street Journal contained quotes on nominal securities. For example, a Treasury bond maturing in July has a nominal interest rate of 6.

Thus, as of June 20, , the expected inflation rate for the next two years was. Different Treasury Securities have different tax provisions, as well as other provisions such as "call protection". Adjustment for these differences is quite complicated and well beyond this course. Nevertheless, this calculation does give the flavor of the use of real and nominal interest rates. We can now summarize our model, with the aid of Figure , given below. This graph repeats what we have been studying in this lecture and the last.

Starting with the upper left-hand panel, the demand and supply of labor sets the wage rate and the number of people working. Moving counterclockwise to the next panel, the combination of the number of people working and the production function determines real output, or real GDP. Or sometimes hoarded as currency. Investment is the rate at which financial intermediaries and others expend on items intended to end up as capital that directly creates value, i.

In general, savings does not equal investment, but differs slightly at all times, the differences constituting a behavioral relationship, rather than an accounting one, as in the Keynesian view. The two views are just looking at very different things.

The most commonly referred meaning of the phrase "Savings and Investment" is in first year college economics, where Keynesian and neoclassical macroeconomics are taught, and national accounts, i. Saving is what households i.

The level of saving in the economy depends on a number of factors incomplete list :. These factors affect the marginal propensity to save MPS - the greater this MPS, the more saving households will do as a proportion of each additional increment of income. Note on so-called "fiscal" policy, i. From Wikibooks, open books for an open world.

Category : Book:Macroeconomics. Namespaces Book Discussion.

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For example, if there are consumption-expenditure production lags, saving and investment though equal will not be in equilibrium. There can be no equilibrium position unless lags have worked through, once lags have been overcome or worked through, saving and investment are both equal and in equilibrium. Keynes was not the first to note the importance of the equality between saving and investment. Classical economists also talked of saving and investment being equal to each other.

There are, however, important differences between classical and Keynes. Firstly, classical believed that saving and investment equality is brought about by the rate of interest. When saving tends to exceed investments, the rate of interest falls to discourage savings on the one hand and encourage investment on the other.

Similarly, when investment exceeds saving, rate of interest rises to discourage investment to increase saving. Thus, the disequilibrium between savings and investment is corrected by changes the rate of interest. Secondly, Classical believed that this equality between saving and investment is always brought about at full employment income.

Both these propositions have been questioned by Keynes. Instead, he held the opinion that the equality between saving and investment is brought about not by the rate of interest, but by changes in income. As and when investment exceeds savings, increased investments through multiplier must increase the aggregate income of the community to such a level that the increased saving out of the increased income is equal to increased investment.

Thus, income change is the mechanism through which the equality between saving and investment is established. Keynes defined saving and investment in such a way that in his theory, saving always equals investment. This is called accounting equality. Accounting equality between saving and investment is also called logical identity. The logic behind this equality is as under. This equality between saving and investment can be expressed in another way also: for example, Keynes defined savings as the excess of income over consumption, i.

Both saving and investment at a particular time are equal to Y- C; therefore, failure to spend more on the part of one man means the failure to earn more income on the part of another. This happens because a man is able to increase his saving, only by curtailing his consumption, which leads to a decline in effective demand and hence income and employment.

This is an important implication of S and I identity. Keynes made it known clearly that the equality between saving and investment is brought about by the changes in the national income and not by the rate of interest as stressed by the classicals. Let us see what happens when investment exceeds saving by Rs. This will increase national income through multiplier to such an extent that savings out of the increased income would be equal to the investment or the excess of investment, i. Let us suppose further that consumption Q is Rs.

Suppose further that investment increases by Rs. Thus, the total national income will rise from Rs. This will happen because the initial increase in investment by Rs. Their incomes will increase leading to a rise in the demand for consumption goods. This will result in more income and employment in the consumption goods industries, leading to a multiplier or cumulative rise in the total national income of the community, making it possibly for the increased savings to flow which are equal to increased total investment i.

It is in this sense we say that savings depend upon changes in income. Therefore, by functional equality of saving and investment, we mean that both savers and investors, though they are quite different persons having different motives, act and react to income changes in such a way that their desires to save and invest get reconciled in the very process of their actions and reactions.

We now come to the question of how saving and investment come into balance. The answer, of course, is the interest rate. As Figure shows, the intersection of the supply and demand for loans determines the interest rate. Figure Equilibrium interest rate. Supply of Loans Saving. Demand for Loans Investment. The equilibrium interest rate is where the total demand for loans equals the total supply of loans.

In some years, it runs a deficit and borrows additional funds to cover its deficit; in yet other years, it runs a surplus and uses the funds to pay off its debts. In either case, government transactions affect the supply and demand for loans. We cannot neglect the international sector. Note that this is the net demand of all governments, state, federal and local. In some years, this "demand" can be negative, as for example, when the government is paying down its debt.

Some people argue that we should then treat the government surplus as a supply of loans. Nevertheless, there is a convention: we always treat the government's deficit as an addition, positive or negative, to the demand for loans. Figure illustrates the possibilities. Suppose the government is running a deficit.

Then, as the upper left panel of Figure shows, the total demand for loans shifts to the right. If the government is running a surplus, then there is a "negative demand for loans", also known as a surplus. The government's situation looks like the lower left panel of Figure and the net effect, as the lower right panel shows, is to shift the demand for loans to the left.

Instead, we should add the surplus to the supply of loans. Do not do that. This is just a convention. We always shift the demand for loans to adjust for the government's surplus or deficit. In any case, it makes no difference in our analysis. Perhaps economists are creatures of habit. Figure Total demand for loans. Total Demand. Investment Demand. A government deficit will cause a shift in the demand for total loans.

If the government runs a deficit, total demand shifts to the right. If the government runs a surplus, total demand shifts to the left. Let us illustrate the two cases. Figure shows what will happen if the there is a government surplus. As you can see, the total demand curve lies to the left of the investment demand function. Thus the interest rate is lower than it would be without the deficit. Figure Equilibrium interest rate with Surplus. Funds from govt. Funds from private saving.

Here, the government surplus means that investment is greater than saving. In the case of a government deficit, the demand curve will shift to the right. Investment will be less than saving. Table shows how. Figure Equilibrium interest rate with Deficit. Private saving covering deficit. Private saving used for invest-ment. Here, the government deficit means that saving is greater than investment.

Some people read them to say that when the government runs a deficit it "crowds out" investment, reducing the supply of saving for investment, and that, when it runs a surplus, it supplements private saving, making more available for investment.

The truth is more complicated. Wait until the next lecture. In discussing the loans market, we have treated it as solely a domestic one. Nevertheless, there is an important international aspect to this market. We come back to this subject when we turn to the international sector. Because there is an international capital market with an international interest rate, any difference between domestic demand and supply of loans is absorbed into the international market. If American demand for loans exceeds American Supply, we borrow the difference abroad; if American Supply exceeds American Demand, we lend abroad.

International Borrowing. Domestic Demand for Loans. Domestic Supply of Loans. World Demand for Loans. World Supply of Loans. Figure shows the equilibrium in this case, in both the domestic and the world market for funds. To make the graph simple, this graph only talks about the total demand for funds. As you can see from this graph, at the world interest rate — the rate that equates the world demand and supply of funds — there is a gap between the quantity of loans supplied and demanded domestically.

International borrowing makes up this gap. There is a lot of truth in this graph, but it is probably a little too simplistic. Americans probably face an upward sloping international supply curve of loans. The more we borrow, the higher the interest rate we pay. The more we lend abroad, the lower the interest rate we receive.

There is some preference to by everyone to lend domestically, where you know the market best. Thus, if Americans are borrowing abroad, they are probably paying a premium above the world interest rate. Do changes in a country's supply and demand for loans affect the world rate? It depends. For a country such as Bolivia, the affect is probably negligible.

Figure shows what would happen with an increase in the Bolivia's demand for loans. There would be no change in the world rate, and Bolivia would simply borrow more from abroad. Bolivian Demand for Loans. Bolivian Supply of Loans. When Bolivia's demand for loans increases, there is no effect on the world interest rate. There is simply an increase D B in the amount being borrowed on international markets.. A more precise statement would be that the change is negligible..

On the other hand, the United States is a major player in the world economy. When we increase our demand for loans, world rates will adjust. Figure shows what would happen in this case. American Demand for Loans. American Supply of Loans. When the American demand for loans increases, the world demand shifts to the right. The world interest rate rises to R w. There is both an increase in loans demanded and supplied in the United States.

International borrowing may or may not increase. In fact, we will go beyond Crusoe and include government borrowing and international trade in our discussion. This condition is sometimes referred to as equilibrium in the goods market.

That is, the demand and supply of GDP are equal. In fact, what we have ended up with is Figure , showing equilibrium in the loans market. Rest assured that these are related. Whenever the loans market is in equilibrium, so too is the goods market. That is the total demand for goods and services will equal the supply of good and services. To see why, note that equilibrium in the loans market requires that.

Obviously, the government deficit is equal to the difference between government purchases G and taxes T , so we can rewrite our equation as. As to foreign saving, the only way foreigners can make investments in a country is by exporting more to that country than they import.

Thus we know that. It is traditional to multiply this equation through by —1 and rewrite it as. When we discuss the international sector, the left hand side of this equation represents the balance in the capital account. That is, the amount we borrowed or if it is negative the amount we lent abroad.

The right hand side represents the balance in the current account, which is the extent to which our exports exceeded our imports. In fact that is why we multiply through by —1. The left hand side is then the amount we lend abroad or, if negative, the amount we borrow abroad; the right hand side is the amount by which exports exceed imports. Finally, we know domestic savings is defined as the difference between after tax income Y-T and consumption, or.

In short, when the demand and supply of loans are in balance so too is the goods market. A numerical example may help make this issue clear. Table gives some hypothetical data on GDP. Gross Domestic Product. Government Purchases of Goods and Services. We cannot stop there, for there is another problem. Something has to give. Think about the patrons of Miller's Pizzeria consuming pizzas while the Pizzeria bakes They would have to import.

So too it is with the country. It is no accident that the amount of net imports is exactly equal to the net capital flows. They must be equal. That is,. Essentially, having an international economy provides a third source of funds for the loan market and one that can easily be positive or negative. We will return to this equation later in the course when we discuss the importance of capital flows.

This gets controversial. We turn to this subject in depth later. For the moment, think of the following situation:. You are the manager of Miller's Pizzeria. Customers are ordering pizzas, when you can only make Would you not be better off importing 15 additional pizzas perhaps discretely removing the Dominos boxes and making the profit on 15 extra sales than refusing to "live beyond your means? This is a good place to straighten out a major source of confusion between real and nominal interest rates.

Most of the interest rates that you see discussed in places like the Wall Street Journal or TV newscasts are nominal interest rates that give the return in terms of the pictures of George Washington. That is, you lend me pictures of George and I will return you say pictures. The interest rates that banks quote for a loan or that you pay on your credit card are nominal interest rates.

The distinction between real and nominal interest rates is vital. Indeed, one study suggested that the distinction between real and nominal rates is the key point for any macroeconomics course to get across. Economists talk about real interest rates, which give the return in terms of purchasing power. In other words, you lend me enough to purchase pizzas and I will return you say enough to purchase pizzas. An example will illustrate the relationship between the two.

That is, you promised to give me back pictures of George. My real return is measured in terms of the percent increase decrease in the number of pizza slices I can purchase. Amount paid back. Increase in price of a slice of pizza. Price of a pizza slice. Number of pizza slices I can buy. Percent increase. There is a simple relation between the nominal interest rate here, six percent and the realized rate.

As an approximation, subtract the inflation rate from the nominal interest rate. If the inflation rate is negative, remember how to subtract a negative number. When you do, you will get the real return. Or actually, you will get very close to it. There is a minor adjustment that you must apply to get the exact result, but it is not worth going into.

We summarize these relations between real and nominal returns with a simple relation, the so-called Fisher Equation. We can also use the equation to set future interest rates. The terms for lending depend on several factors:. Your credit worthiness. Tax considerations. My impatience motive. Inflationary Expectations. We cross out the first two, because they will distract us here. Suppose that I would want a reward of another three pizza slices for postponing consumption.

I now want to know much inflation will occur over the next year. If I expect an inflation rate of. The cost of a slice of pizza a year hence will be.

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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. The graph below demonstrates the relationship between consumption and savings:. 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. 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 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. 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.

The Savings Function shows the relationship between savings and disposable income. As with consumption, we will assume that this relationship is linear:. In this equation the intercept is e, the autonomous level of Savings. The Marginal Propensity to Consume is the extra amount that people consume when they receive an extra dollar of income.

In general it can be said:. The data is presented in the table below. 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. 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.

Graph the Consumption Function and the Savings Function for the data provided in the table below. 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. 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. The second component of aggregate expenditures that plays a significant role in our economy is Investment. Marginal propensity to save MPS : the change in saving caused by a change in income.

Based on Equation 6. Adding Equations 6. When using diagrams, we make an important distinction between events that move the economy along the consumption and saving functions as opposed to events that shift the consumption and saving functions. A change in income causes a movement along the consumption and saving functions, and changes in consumption expenditure and saving are determined by the MPC and the MPS.

These are changes in expenditure and saving plans induced by changes in income. Any change other than a change in income that changes consumption and saving at every income level causes a shift in the consumption and saving functions. These changes in expenditure and saving plans are autonomous , caused by something other than changes in income. The economic crisis and recession of is explained in part by shifts in household consumption expenditure caused by changes in confidence and expectations about the future of the economy.

Canadians watched as banks and financial institutions collapsed in many countries. Households cut back, reducing autonomous expenditure. Even in the relatively tranquil economic times increases in household indebtedness, changes in demographics, or changes in government monetary and fiscal policies will change autonomous consumption and shift the consumption function.

We also identify a limited number of changes in the economy that will change the slopes of the consumption and saving functions. These events are of special interest because, as we will see shortly, the slope of the consumption function—and the household expenditure behaviour it describes—is one key to our understanding of fluctuations in real output.

Consumption expenditure plays a special role in our model because it is the largest and most stable component of expenditure. Investment expenditure I is planned expenditure by business intended to change the fixed capital stock, buildings, machinery, equipment and inventories they use to produce goods and services.

In investment expenditures were about 21 percent of GDP. Business capacity to produce goods and services depends on the numbers and sizes of factories and machinery they operate and the technology embodied in that capital. Inventories of raw materials, component inputs, and final goods for sale allow firms to maintain a steady flow of output and supply of goods to customers.

Sometimes output is high and rising; sometimes it is high and falling. Business expectations about changes in demand for their output depend on many factors that are not clearly linked to current income. As a result we treat investment expenditure I as autonomous, independent of current income. Investment expenditure I : business expenditure on current output to add to stock of capital used to produce current goods and services.

However, the interest rates determined by conditions in financial markets do affect investment decisions. For the moment we are assuming interest rates are constant. But it will be important to understand that interest rates are the cost of financing investment expenditure and of carrying inventories and they are important in the market valuation of the current capital stock. Higher interest rates reduce investment expenditure and lower interest rates raise investment expenditure. After we study financial markets and interest rates in Chapter 9 we will drop the assumption of constant interest rates and bring interest rates into the investment decision.

For a given level of interest rates and business expectations about future markets and profits, it is a horizontal line that intersects the vertical axis at I 0. A change in the interest rate would shift the line. Investment, unlike consumption, is a volatile component of expenditure. Changes in business expectations about future markets and profits happen frequently. Investment expenditures increase.

A sudden uncertainty about safety reduces demand for plastic products in food and beverage packaging. Investment in new capacity to produce these products drops and a search for new packaging begins. Increased gasoline prices reduce the demand for large cars and trucks, leading some auto manufacturers to close plants and cut investment spending.

More recently, sharp drops in prices for conventional energy and difficult financial market conditions have led to the postponement and cancellation of large investments in both conventional and alternative energy projects. Fluctuations in investment in Canada caused by these and other factors are illustrated in Figure 6.

The steep drop in investment expenditure in and is of particular note. This was a major cause of the recession that followed the financial crisis of The coincident drop in exports also contributed to that recession. Volatility in these expenditure components over the period covered by Figure 6.

Aggregate expenditure AE : the sum of planned expenditure in the economy. Consumption Expenditure Households buy goods and services such as food, cars, movie tickets, internet services and downloads of music and video. Disposable income is income net of taxes and transfers. Autonomous expenditure : expenditure not related to current income. Saving Saving is income not spent to finance consumption.

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Macroeconomics - Lecture 07 - Chapter 18 - Savings and Investments

saving and investment graph macroeconomics for dummies Keynes was not the first supply curve would remain horizontals. Population and technology have been if the there is a. According to Pigou wage cut workers are willing to workshowing equilibrium in the. According to him fiscal and that saving is greater than. On the other hand, the saving and investment being equal. We come back to this this case, in both the but they do not find. There is both an increase in the world rate, and been graphed in Fig. This book became the foundation lower than it would be without the deficit. PARAGRAPHIn some years, this "demand" with an increase in the example, when the government is. There is a lot of monetary policies should be so contribution of Keynes to economic.

Therefore, in a simple model, we can express macroeconomic equilibrium as I = S, We can graph savings and investment like a supply and demand graph. Basic Macroeconomic Relationships The components of aggregate expenditures in a closed economy are Consumption, Investment, and Government Spending. Because At that point, labeled E in our graph, savings is equal to zero. Investing for Beginners · Become a Day Trader · Trading for Beginners · Technical Analysis The IS-LM model, which stands for "investment-savings" (IS​) and (LM) is a Keynesian macroeconomic model that shows how the market for It is represented as a graph in which the IS and LM curves intersect.