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Subject ECONOMICS

Paper No and Title 14: Economics of Growth and Development II

Module No and Title 24: Saving, Investment and Inflation

Module Tag ECO_P14_M24

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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TABLE OF CONTENTS

1. Learning Outcomes
2. Introduction
3. Saving
4. Investment
5. Inflation
6. Summary

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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1. Learning Outcomes

After studying this module, you shall be able to

 Know the importance of saving, investment and inflation

 Learn why studying saving, investment and inflation is important for economic
growth
 Identify the factors that pull an economy away from full-fledged growth process
 Evaluate saving, investment and inflation
 Analyse the factors affecting economic growth

2. Introduction

Saving in simple words is that part of money income, which is not spent on consumption.
All factors of production receive money income as reward for their services. All this
income is not spent on consumption. Therefore, excess of income over consumption
expenditure is called savings i.e., S= Y-C where S is saving; Y is income and C is
consumption expenditure. Since savings are derived with the help of income and
consumption function, saving function expresses the relationship between the level of
income and the amount of savings in an economy i.e., Y=C+S, if we assume that the
economy is a two sector model without the presence of Government and Foreign trade.

3. Saving

The saving function, therefore, expresses the relationship between the changes in desired
saving in response to the change in disposable income. The income earner takes decision
about either consumption or saving and the other component is the residual. Since

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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income and saving are directly related; rich people will

save more than the poor not only in absolute terms but in percentage terms also. Saving
function can be derived

graphically with the help of Y line and consumption function as follows.

With income on X axis and consumption and saving on Y axis, the 45˚ line Y= C+S. The
consumption function is shown by CC and the saving curve by SS curve. At zero income
level consumption is positive, therefore savings are negative. At income level Yº
consumption equals income therefore savings is zero. Saving is positive at income levels
greater than Yº and SS curve is the vertical distance between 45˚ line and the CC curve.
Thus saving curve is an upward rising curve showing a positive relationship between
income and savings.

Savings in any economy are contributed by the household sector, the private corporate
sector and the government sector. Besides the level of income in an economy which is
the prime determinant of savings, it is also affected by the tax policy of the government
as direct taxes affect the disposable income of the people. A higher tax rate would
increase the compulsory saving of the economy. Similarly, higher deductions towards
ECONOMICS Paper 14: Economics of Growth and Development II
Module 24: Saving, investment and inflation
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social security like provident fund and insurance etc

would also increase saving level. Although the relationship between price rise and saving
is uncertain yet on average the increase in price level has a positive effect on saving.
Besides savings in any economy is also affected by the distribution of income. More
equitable distribution of income lowers the propensity to save. Even a higher real interest
rate will give a greater return on saving, although the relationship between the two is not
very simple. Since people have a strong preference for present consumption over future,
they will forego present consumption only if they are paid quite a high premium in terms
of high rate of interest.

The poor expectations for future economic growth will increase household’s savings in
the present as precaution.

All the above stated factors do affect the level of saving in an economy although the
relationship between saving and these factors is not straight forward and simple.

4. Investment

Investment in macro economics analysis refers to the value of that part of the aggregate
output for any given time period which takes the form of new structures, new capital
equipment and changes in business inventories. It, thus refers to the acquisition and
increase in the real assets and expenditure on these real assets may include.

(a) Production or purchase of new machinery, plant and equipment etc.

(b) Creation of new physical assets such as roads, dams, canals, airport, power plants,
and railway tracks etc.
(c) Inventory building i.e., stocks of raw material, semi finished goods and stocks of
unsold finished goods.

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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Thus, investment in any economy is very important as it

creates capital. It should include not only investment in real assets like plant and
machinery but should also include human capital. Its aim is to increase the productive
capacity and the efficiency of the economy.

In accounting sense, savings and investment are always equal as it is based on the static
approach. But in real sense the equality between the two should be seen in terms of
planned and unplanned investment. While planned investment is the amount which all
the firms plan or desire to invest known as ex-ante investment, the unplanned investment
is the change in business inventories due to a discrepancy between total demand and total
supply. If supply exceeds demand business inventories will increase. Actual investment
known as ex-post investment is a sum of planned and unplanned investment and this
actual investment equals savings at every level of income. Thus in monetary terms the
relationship between savings and investment is modeled rather than being an accounting
identity. It is the unplanned investment in terms of stock and inventory which plays a
balancing act in equating desired savings to desired investment though its effect on level
of income.
Since investment means creation of additional productive capacity and is taken in terms
of the creation of real assets in the form of new structures, workshops, factors etc.; it
should not include financial investment in the form of shares, debentures, govt. bond and
equities etc. Because these are simply transfer of rights of the title and the real capital of
the economy is left unchanged.
Investment expenditure in any economy is of two types (a) induced investment and (b)
autonomous investment. Induced investment is a function of income and is undertaken as
a result of change in the level of income and thus consumption. This type of investment
depends on profit expectations as the entrepreneurs anticipate high sales of final goods.
Any increase in the level of income and employment will increase the demand for
consumer goods which in turn will push up the level of investment. This functional
relationship between income and investment is depicted graphically as follows

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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By taking income on the X axis and investment on the Y axis we can draw an induced
investment curve which slopes upward from left to right. It shows that induced
investment is income elastic and goes on increasing as the income level in the economy
increases.
Autonomous investment on the other hand is independently determined by a large
number of exogenous factors like population growth, technological changes and new
inventions and discoveries. Levels of income and consumption expenditure do not have
any impact on this type of investment. This investment is not affected by profit motive.
Since autonomous investment remains unchanged at each level of income it is income
inelastic. Since investment is shown graphically as follows:

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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The autonomous investment curve is constant at irrespective of the level of income and is
represented by a horizontal straight line parallel to X axis.

Investment decisions in any economy are also affected by the different sectors in which
the investment expenditure is being done. The motivations for investment in the public
and private sector are different. In the public sector profit maximization may not be the
only basis for investment. The decisions here may be influenced by the social and
political factors. The cost benefit techniques help in assessing the social profitability and
the social cost of the proposed investment as the social welfare considerations are more
important.

On the other hand, investment decisions in the private sector are motivated by profit
maximization. The expected profitability is the main motive of the private entrepreneurs.
While investing in new machines or factories the private investors compare expected
returns from an investment with its present cost to determine its profitability. To
determine whether investment expenditure would be profitable or not, the expected
returns from the asset are compared with the cost of financing investment which involves
the concept of rate of interest. Keynes has used the concept of marginal efficiency of
ECONOMICS Paper 14: Economics of Growth and Development II
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capital to measure the expected returns on the capital

assets and has compared it with rate of interest in order to determine the investment
decisions.

5. Inflation
The concept of inflation is a new experience for the world economic markets as in the pre
twentieth century the upward pressure of prices had been very little due to gold and other
metallic standards, after the end of gold standard strong political pressures often resulted
in issuing more money which resulted in the increase in price level. This ordinarily
inflation is a situation in which the general price level in an economy is rising and the
value of money is falling. It reflects a situation where the demand for goods and services
exceeds their supply. It can be the result of a higher demand by the private sector or/and
the government expenditure being more than the revenues or could be due to a shortfall
in supply. Inflation could also be the result of an increase in the cost of production but it

will persist only if it is accompanied by an increase in money supply, which shows that
inflation is basically a monetary phenomenon. But every rise in prices is not to be taken
as inflation. Thus inflation is a persistent upward movement in the price level at a
substantial rate over a long period of time. The word persistent rise is important because
if the price level goes up today and falls tomorrow it will not imply inflation but only
short term fluctuations. Similarly, the term general price level is also important, as it is
not concerned with the rise in the price of a particular commodity or a small group of
commodities.

Economists are of the view that a mild degree of inflation is not only desirable but is a
necessary condition of economic growth especially in developing economies with
unemployed manpower and underutilized resources. But the positive effect in terms of
inducement to investors remains only as long as inflation is kept under control. Initially,
with the rise in price level the profit margins of the producers tend to widen and
encourage more investment leading to more employment and income.
ECONOMICS Paper 14: Economics of Growth and Development II
Module 24: Saving, investment and inflation
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But a persistent rise in prices over a long period of time will increase the cost of living
leaving a dent in the level of savings. Inflation is in fact, a leaking bucket and will not
only erode the purchasing power of the society but would also result in some other
economic mechanisms.

Under the money illusion consumers can over estimate the real value of their inflated
revenue and will increase their real consumption on the basis of perception of an increase
in income which would actually lead to a decrease in saving.

A high level of inflation would compel the consumers to spend the major part of their
income in present leaving a small part of saving for the future especially of their income
is not strictly indexed to the consumer price index.
Some economists believe that under conditions of inflation, economic agents try to
compensate the depreciation in their real savings by stepping up their current savings.
But the empirical evidence about different countries is not conclusive. The increase in
prices of goods and services puts pressure on savings because the saved amount will be
able to buy lesser number of goods and services.

In fact, inflation causes many distortions in the economy. When prices rise over a long
period, people who are retired and those living on fixed income cannot buy as much as
they could earlier. This also discourages savings as the worth of money is more in the
present than in the future.

Inflation is not only affects the savings adversely but also makes the financing of
investment more difficult as a certain level of savings is always required for it. It even
makes difficult for the business to plan for the future as it becomes harder to predict the
future demand at increasing prices and therefore the decisions about how much should be
produced are also affected.

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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Another adverse impact of inflation is in terms of generation of uncertainty of future

prices, interest rates and exchange rate. Uncertainty increases the risks among potential
trade partners about investment and productive activity of the firms and markets.

Moreover, inflation not only disrupts the operations of a nation’s financial institutions
and markets within the economy but discourage their integration with the rest of the
world’s market.
Amongst different types of investments, the effect of inflation on a particular portfolio
will depend on the types of securities it has. If investment is done only in stocks one
should not worry about inflation. But the real problem of inflation is that it discourages
investors by reducing their confidence in those investments which take long time to
mature.

The effect of inflation on investment is also felt indirectly as inflation increases both
transaction and information costs. The uncertainty on the rate of inflation also leads to
reluctance amongst individuals. It inhibits investment which ultimately affects economic
growth. Even the intermediaries are not willing to provide long term funds for capital
formation during inflationary environment. Thus both borrowers and lenders are reluctant
to enter into long term contracts.
The Government tries to protect certain sectors of the economy during high inflation. A
ceiling on interest rate is put. Such controls may lead to inefficient allocation of capital
in the economy affecting economic growth adversely.

Moreover, the fixed income investors are also hit hard by inflation as the real return in
terms of purchasing power of the investors is less than the nominal return as the real rate
of return is in fact measured by nominal rate of return reduced by the rate of inflation.
The small middle class investors also feel uneasy particularly if they are retires as it
becomes difficult for them to make an adjustment between pensions and financial
investments. Therefore, it is suggested that social security payments are indexed to

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation
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inflation so that the effect of inflation is compensated.

Moreover one should invest in securities with fixed returns although such securities offer
lower returns.

Although there are other significant effects of non inflation as it leads to the growth of
black money; creates high cost economy and raises the level of plan expenditure but there
is no doubt that sustained inflation is damaging to long run growth and the financial

system in general. Inflation leads to lower real returns on all assets which interface with
the functioning of financial markets and thus have a damaging effect on the credit
market. The supply of credit for funding investment is thus which reduced which in
terms would damage the economic growth.

6. Summary

 As Y= C+S, we arrive at S= Y-C where S is saving; Y is income and C is

consumption expenditure.
 Investment is necessary for an economy to grow
 Inflation is an evil which every country wants to avoid at any cost but a country
cannot run away from it.

ECONOMICS Paper 14: Economics of Growth and Development II

Module 24: Saving, investment and inflation