Consumption and investment relationship

The Relationship between Saving and Investment (Explained With Diagram)

consumption and investment relationship

Define the term consumption, saving and investment; Explain the absolute income hypothesis, recognising the relationship between consumption and saving. CONSUMPTION AND INVESTMENT FUNCTION - A Group K Presentation. It does not allow for any effect of consumption on income, but assumes that the only source of the relationship comes from the effect of changes in income on.

From this we get the following equation: 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: 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.

consumption and investment relationship

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.

consumption and investment relationship

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.

Relationship between Saving and Investment | Economics

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.

consumption and investment relationship

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. 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. It will be seen from the Fig. Therefore, OY is the equilibrium level of income. 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.

Relationship between Saving and Investment | Economics

It will be seen that with the rise in income to OY2, saving rises and becomes equal to investment. 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.

That portion of national income which is not spend on consumption goods is saved. On the output side, firms either sell the goods they produce or put them into inventory, for future sale. Some of the inventories business firms hold is planned desiredbecause businesses require inventories to survive i. Some of it is unplanned undesired — business may be surprised by a brief recession that spoils their sales forecasts. Both intended and unintended inventory build ups are considered investment.

The goods that are not demanded by consumers are, by definition, demanded by business firms, i. In fact, investment is the demand for capital goods.

Since firms will reduce output, in equilibrium the amount companies invest in the amount they wish to invest including inventoriesgiven current market conditions. The Keynesian short-run consumption function tells us how much people will wish to consume at each level of income. But since saving is a residue i. Saving is just income minus consumption: National income equilibrium occurs at point E where the desired saving function intersects the desired investment function.

But planned or desired ex-ante saving is equal to planned or desired ex-ante investment only when national income is in equilibrium. When we talk of saving and investment being equal, we are referring to the observed behaviour of an economy; a study of what has actually happened or what has been realised. But the Keynesian analysis of income determination revolves around the intended nature of such variables as saving and investment. These plans to save and invest lead to changes in the income flow, with different equilibrium levels being reached.

Decisions to save and invest are constantly being made by different groups of people at different times and for different reasons. So there is very little chance of these plans being equal to each other within the same time period. When any discrepancy between the plans to save and invest occurs a change in the level of income brings about a state of disequilibrium, and as income continues to change so do these plans get readjusted until a level of income is reached where planned saving and investment are once more equal to each other.

It is only then that equilibrium has been attained where there is no tendency for the level of income and employment to alter.

The Relationship between Saving and Investment (Explained With Diagram)

This process is facilitated by a multiplied change in income which operates both in an upward and in a downward direction. A simple numerical example may clarify the above: The table gives a consumption function, from which saving plans can be obtained. When income is the consumption schedule indicates that will be consumed, leaving the remainder to be saved.