Economics 102H
Principles of Macroeconomics, Honors Section
Spring 2001

Lecture 8

Investment, Saving, and the Real Interest Rate (Chapter 10)


The key questions in this chapter are:
How are business sector investment decisions made?
How are household sector saving and consumption decisions made?
How do these decisions influence the real interest rate?

Note that these choices along with labor supply and labor demand decisions will essentially determine macroeconomic activity in the two sector economy. In the four-sector economy we must also account for certain decisions of the government and foreign sectors.


Capital and Interest

The capital stock of the economy is the quantity of plant, equipment, buildings, and inventories. Gross investment is the purchase of new capital and additions to inventories; depreciation is the amount of capital that is worn out each year. Net investment is the difference between gross investment and depreciation and measures the actual change in the capital stock.

Firms acquire additional capital to increase future output, sales, and, hopefully, profits. The interest rate measures the opportunity cost of purchasing capital (and, in equilibrium, it must also equal the return on capital, according to the MP=MC condition). It is useful to distinguish between the nominal interest rate and the real interest rate. The nominal interest rate is determined by the number of dollars the borrower is obligated to pay in interest payments and is the interest rate non-economists usually are discussing when they talk about interest rates. The real interest rate is equal to the nominal interest rate minus the rate of inflation. It measures interest payments in terms of goods rather than dollars. Thus, a nominal interest rate of 10% per year for a one-year loan means that if you borrow $X today, you must give up 1.1x$X one year from now. A real interest rate of 10% per year means that if you borrow the dollar equivalent of X units of goods today, you must give up the dollar equivalent of 1.1xX units of good one year from now. Economists generally assume that it is the (expected) real interest rate that is relevant for decision-making purposes.




Investment decisions by the business sector are assumed to depend primarily on two factors:

expected future profits (which positively affect investment demand)
the real interest rate (which negatively affects investment demand)

Investment demand is the relationship between the level of planned investment and the real interest rate all else equal. The investment demand curve is thus a downward sloping curve relating these two economic variables.

Changes in investment demand occur primarily through changes in expected future profits. Expected future profits are largely influenced by forecasts of long-run economic trends (technology) and short-run economic trends (business cycle). Technological advances generally increase business sector profits; business sector profits are "procyclical", rising during expansions and falling during recessions.



Saving and Consumption Decisions

Investment demand can be thought of as generating a demand for funds in the economy's financial markets. The source of these funds, i.e., the supply of funds in the economy's financial markets arises from national saving and loans from the rest of the world (i.e., S-(G-NT)-NX)). Here we treat G-NT and NX as fixed and focus on the determination of household saving and, in particular, the relationship between household saving and the real interest rate.


Recall that households receive Y-NT units of real disposable income per unit of time which they allocate between C and S (since S = Y-NT-C). The most important factors that are assumed to determine this allocation are:

disposable income itself;
the real interest rate;
real wealth; and,
expected future disposable income

We assume that, all else equal:
C and S increase when disposable income increases;
C decreases and S increases when the real interest rate increases;
C increases and S decreases when real wealth increases; and,
C increases and S decreases when expected future disposable income increases.

{Digression - The change in C relative to the change in Y-NT ()C/)(Y-NT)) is called the marginal propensity to consume ,i.e, the MPC. The change in S relative to the change in Y-NT ()S/)(Y-NT)) is called the marginal propensity to save, i.e., the MPS. Note that it must be that MPC + MPS = 1. We are assuming that 0 < MPC < 1 and, therefore, that 0 < MPS < 1. The MPC and MPS will be important to us later in the course. The saving rate is S/(Y-NT), which is also called the average propensity to save, i.e., the APC.}

The inverse relationship between the real interest rate and desired consumption, all else equal, defines the consumption demand curve. Note that the consumption demand curve will be downward sloping and shift to the right (left) when current or expected future disposable income increases (decreases) or when real wealth increases (decreases).

The direct relationship between the real interest rate and desired saving, all else equal, defines the saving supply curve, which explains the desired supply of funds into financial markets from the household sector. Note that the saving supply curve will be upward sloping and shift to the right (left) when current disposable income increases (decreases), when expected future disposable income decreases (increases), or when real wealth decreases (increases).


Capital Market Equilibrium

In the two-sector economy (i.e., no government or foreign sector), capital market equilibrium is determined by the intersection of the investment demand and saving supply schedule. This determines the market clearing real interest rate at which the quantity of funds supplied (savings supply) is equal to the quantity of funds demanded (investment demand). Changes in the capital market equilibrium occur when investment demand or saving supply shift.

In the three-sector economy (i.e., the economy with a government sector but without a foreign sector), the government’s budget deficit or surplus helps determine the equilibrium interest rate. If the government runs a budget deficit, the amount of that deficit gets added to the investment demand schedule to determine the demand for funds in the capital market. Note that the larger the deficit, the greater the demand for funds and the higher the equilibrium interest rate. Note too that at the higher equilibrium interest rate the quantity supplied of funds will increase. Some of these additional funds will go to the government and some will go to the business sector. However, the greater the deficit, the less the business sector will get from the financial market; in other words, the increase in the quantity of funds supplied will be less than the size of the deficit. {Make sure you understand why this is the case!} If, on the other hand, the government runs a budget surplus, the supply of funds to the capital market will increase by the amount of this surplus, lowering real interest rates, lowering household sector saving, but increasing national saving and investment. {Why?}

Suppose we add a foreign sector to complete the economy and there are no barriers or costs to buying and selling financial assets across borders. Suppose also that there are no risk differences associated with assets from different countries. Then, a supplier of funds will lend to the highest bidder, regardless of what country that bidder comes from. Similarly, a demander of funds will borrow from the cheapest international source. It follows that international capital markets will be fuller integrated: there will be a world-wide demand for funds, a world-wide supply of funds, and a world-wide equilibrium real interest rate (at which the world-wide quantity supplied of funds is equal to the world-wide quantity demanded of funds). Notice that in this case, the equilibrium quantity supplied of funds from a given country need not equal the quantity demanded by that country.