8.

Private & Public Savings:

8.1 Introduction to Injections & Leakages (S+I)

 As we know from the circular flow of economic activity, the economy is in equilibrium when
total domestic output equals total expenditures on domestic outputY=C+I+G+NX.
 In a closed economy and ignoring government and investment, total spending by domestic
residents (C) could only be spent on domestic goods and total output
was sold entirely to domestic residents.
 Equilibrium output is expressed by Y =C .
 In equilibrium total spending C has to equal total output. Looking at
the AE model with just consumption, we know that equilibrium
occurs at point A where the consumption function crosses the 450
line. Corresponding with this is point a in the bottom graph where
savings equals zero (savings curve crosses the X-axis).All income
is spent on consumption. If Y=C, then S=0.
 Let’s assume that consumers decide not to spend some of their
income and decrease consumption (C-C’: A to B-top graph). This
causes total expenditures (C) to be less than output (below the 45 0
line)Point B. The amount saved would be Y minus C (income less
expenditures).
 Therefore, Y-C equals savings. The increase in savings from zero at Y* is shown in the bottom
graph as point b. With no change in income, a decrease in consumption means that savings had
to go upPoint a-b
 As we know, if AE is less than total output as shown by point B in the top graph, firms will cut
back production (moving the economy to point C). As this happens, they reduce the amount of
labor hired and income decreases (output and income decrease to Y0).
 As income decreases, consumption decreases (moving along the curve) from B to C and savings
decreases (moving along the curve) from b to c. This happens until total consumption (total
expenditures) equals total output and again savings is zero.
 The only way for consumers to save and for the economy to not contract (stay at Y*) would be if
someone else borrowed the savings and then spent it back in
the economy.
 In macroeconomics this is illustrated by firms borrowing the
savings and investing in capital. Let’s assume that whatever
consumers save will be borrowed by firms and spent in the
economy as investment. This is a fairly good assumption as
we are really just assuming there are projects firms can invest
in with positive rates of return.
 As firms borrow the savings and spend it as investment,
savings is injected back into the economy as investment
spending (I). This is added to consumption in the top graph
bring AE (C+I) equal to output at the original level (point A).
In the bottom graph, investment is a horizontal line as we are
assuming investment is not affected by the level of income
(only the level of savings and the interest rate). Therefore,
 with firms borrowing all available savings, the economy does not contract to point C when
consumers save.
 Equilibrium:
 Y=AEY=C+I or we can write this in terms of savings:
o Y-C=IS=Iequilibrium is where savings equals investment (point b in the bottom
graph).S=I is known as leakages equals injections.

7.1 Government & Public Savings

 We can now introduce government to see how this changes the circular flow. Governments tax
other economic agents which is essentially another leakage, but then spends the tax dollars back
in the economy through government spending. Although the government taxes both firms and
consumers, we assume only consumers are taxed to keep things simple.
 Example: Ignoring government and assuming that income is $100, consumer’s MPC is .80, and
consumption is $80 (MPC*Y). This means that savings would be $20. Y-C=S100-80=20. This
also means for there to be equilibrium investment must equal $20S=I.
 Adding taxes causes consumers disposable income to decrease (Y d=Y-T). If taxes are $15
(assume no government spending just taxes), consumers no longer have 100 income, which will
reduce consumption.
 When disposable income decreases by 15 (due to the taxes of $15), the consumer will decrease
consumption by 12 (.8*15: ∆C=MPC*∆Y) and decrease savings by 3 (.2*15: ∆S=MPS*∆Y).
Consumption decreases from 80 to 68, and the consumer’s savings decreases from 20 to 17.
 We now have:
o Income(Y)=100
o Consumption=68
o Consumer’s savings=17Private Savings
o Investment now decreases from 20 to 17 to match consumer’s savings.
 Total spending is therefore 85 (68 in consumption and 17 in investment). Because the
government took 15 from consumers and did not spend it, AE<Y85<100.
 Also, because the government collected $15 but did not spend it, the government is essentially
saving the $15. The government will save this amount in a bank, which means it will be available
for investment.
 In the above example, we assumed investment equaled private savings, but now we will assume
again, that firms borrow all available savings (national), both private and government (public)
and spend it on investment. Therefore, when defining savings, we look at all savings not just
savings by consumers.
 In the above example, savings for consumers was Y-T-C 85-68=17. However, total national
savings will equal Y-C-G100-68-0=32. The 32 in national savings represents the 17 in
private savings and the 15 in public savings (T-G=15-0).
 Assuming forms also borrow the $15 in public savings, we have the following:
o Y=100, C=68, G=0, & I=32
o Y=C+I+G100=68+32+0100=100
o Y-C-G=100-68-0=32=S
o Therefore, AE=Y and S=I

2
National Savings=Private Savings + Public Savings
 As shown, private savings in the above example equaled 17 (Y-T-C) and public savings equaled
15, bringing national savings to 32. We can derive an equation that separates it into private and
public.
 Starting with our equilibrium condition of Y=C+I+G, we subtract taxes from both sides to get the
following equation: Y-T=C+I+G-T
o subtracting consumption from both sides gives us
o Y-T-C=I+G-T subtracting (G-T) from both sides.
o Y-T-C-(G-T)=I  -(G-T) can be written as +(T-G)
o (Y-T-C)+(T-G)=I National Savings=(Y-T-C)+(T-G) Private savings (Y-T-C) plus
Public savings.
o (T-G) equals national savings. In the above example, we had:
o Private Savings=Y-C-T100-68-15=17
o Public Savings=T-G=15
o National Savings=15+17=32
 Therefore, if the government taxes more than it spends (T-G>0), it adds to national savings (17 to
32). If the government spends more than it taxes (T-G<0), it utilizes some of the private savings
crowding out investment.
 In the above example, government taxed more than it spent (T-G=15-0=15) causing national
savings to go up from 20 to 32 of which 17 is private (private savings went from 20 down to 17,
then the government added 15 to savings). This caused investment to increase as firms absorbed
the excess savings through borrowing.
 Y=C+I+G 100=68+32+0 and S=I32=32

 If the government spends the 15 in tax revenue (T=G), then investment must equal private
savings of 17, but G now equals 15: Y=C+I+G100=68+17+15 Y-C-G=I100-68-
15=17S=I17=17.
 Therefore, as long as the government spends all it collects in taxes (T=G), there will be
equilibrium. Also, when T=G, national savings will equal private savings
 SN=Y-C-G100-68-15=17 and private savings is Y-C-T=100-68-15=17.
 If the government spends less than it collects (T>G), and this will add to national savings as
shown above.
 Let’s assume that government spending is $5T-G15-5=10This means that there will be
public savings of $10.
 C+I+G=68+17+5=90Y≠C+I+G100≠ 90without investment adjusting to the extra 10 in
savings, expenditures are less than output and savings is less than investment (17).
 Y-C-G= 100-68-5=27=SS≠ I27≠ 17
 Public savings goes up by 10 leading to higher investment (17 to 27), and government spending
changes form 0 to 5.
 Therefore, because national savings is 27 (private savings of 17 plus public savings of 10), in
order for there to be equilibrium, investment must equal 27 (national savings=public and private).

3
 This means firms borrow all national savings and spend it. When the government taxes more than
it spends, it adds to national savings leading to more investment.
 When the government spends more than it collects.
 Let’s assume that taxes are again 15, but now government spending is 25.
 C+I+G=68+17+25=110Y≠ C+I+G100≠ 110AE>Y
 Y-C-G=100-68-25=7S=I7≠ 17S<Ithe government took some of the savings to over the
budget deficit (G>T) of 10.
 Therefore, when the government spends more than they collect in taxes, national savings is lower
than private savingsPrivate Savings=Y-C-T=100-68-15=17 but national savings is Y-C-
G=100-68-25=7. Here we can see that public savings is -10T-G=15-25=-10 and private savings
is 17. National savings is 17+(-10)=7.Therefore, in order to be equilibrium investment must
decrease to 7.
 Y=C+I+G100=68+7+25. Or Y-C-G=I100-68-25=7
 Therefore, when the government spends more than it collects, it borrows some of the
private savings that would usually go towards investment. This is usually described as:
when the government runs a deficit (spends more than it collects) it crowds out private
investment.
 Our equilibrium condition in the goods market is Y=C+I+G, which can be written from the perspective
of leakages and injections: Y-C-G=ISN=I. Y represents the total amount of income generated in the
economy. If we subtract total expenditures in the economy on goods and services from income, we have
income less expenditures which is national savings. Although It is true that investment is also an
expenditure on goods and services in the economy, we have assumed that investment is financed
entirely from borrowed funds (savings).
 National Savings=Private Savings + Public Savings
o SN=(Y-T-C) + (T-G) = National SavingsNational savings is the summation of private savings
and public savings.
 Private savings: SP=Y-T-C
o Total Income less taxes & consumption expenditures equals private savings.
 Public savings: T-G
o The taxes taken by the government represent a decrease in consumption and savings by
individuals (MPC+MPS=1); however, these dollars remain in our circular flow. Therefore, they
must either be saved (which means they will be used by firmsInvestment) or consumed by the
government (counted as part of government spending (G)). Government consumption is referred
to as government spending and government savings is referred to as public savings.
 If tax revenue is greater than spending (G), there is positive public savings T-G>0.
 If tax revenue is less than government spending, there is negative public savings or
government borrowings.
8.2 Factors Affecting Savings SN=(Y-T-C) + (T-G)
 National savings is the summation of private savings and public savings.
o Private savings: Y-T-CTotal Income less taxes & consumption expenditures equals private
savings.
 S Priv =Y −T −C
 C=C a+ mpc ( Y −T )

4
  S Priv =Y −T −(C a+ mpc ( Y −T ))
 mpc=δ
 S Priv =Y −T −(C a+ δ ( Y −T ) )
 S Priv =Y −T −(C a+ δ Y −δ T )
 S Priv =Y −T −C a −δ Y +δ T
o Public savings: T-GThe taxes taken by the government represent a decrease in consumption
and savings by individuals; however, these dollars remain in our circular flow. Therefore, they
must either be saved or consumed by the government. Government consumption is referred to as
government spending and government savings is referred to as public savings.
 If tax revenue is greater than spending (G), there is positive public savings T-
G>0.
 If tax revenue is less than government spending, there is negative public savings
or government borrowings.
 We can write national savings as a sum of the two equations for savings.
 National Savings: National Savings=Private Savings + Public Savings
 S N =Y −T −C a−δ Y + δ T +T −G
8.2.1 Government Spending:
 The more money the government spends, the less
tax revenues would be saved decreasing national
savings. On the other hand, if the government
spends less than the taxes collected, national
savings increases.
 Starting from a balanced budget position (G=T)
and holding taxes constant, an increase in
government spending increases G, but decreases
the availability of savings for private investment.
 The increase in G shifts our AE upward and
expenditures increase from A to B. At the same
time, the increase in G shifts our savings
downward (S to S’: a to b). As shown before, this leads to AE>Y and I>S.
 SN=(Y-T-C)+(T-G): GS
 On the other hand, a decrease G starting form T=G leads to a decrease in AE shifting the AE curve
downward (A-B) and an increase in savings (S to S’) causing the savings curve to shift upward (a-b).
This leads to AE<Y and S>I.
 SN=(Y-T-C)+(T-G): GS

8.2.2 Income:
 Changes in income occur through the multiplier effect when there is a change in AE. As we know,
consumers can either spend or save their income. We know that as
income changes, consumption changes by the MPC (∆C=∆Y*MPC), and
savings changes by the MPS (∆S=∆Y*MPS).
 We can use the example above for the change in government spending to
show how savings changes through the multiplier effect.

5
 Starting with AE>Y and S<I from the increase in Government spending, we know that firms will
respond to the excess demand by increasing output which requires hiring more workers and increase
income.
 As income increases, part of the additional income is used for consumption (∆C=MPC*∆Y) as shown as
a movement from point B to point C along the AE line-top graph. In addition, some of the additional
income is also saved (MPC+MPS=1)(∆S=MPS*∆Y) as shown in the bottom graph as a movement
from B to C up the savings curve.
 SN=(Y-T-C)+(T-G)YS
 On the other hand, starting at AE<Y and S>I from the decrease in AE,
firms will respond to the surplus in G&S by decreasing output. This causes
a multiplier effect as firms lay off workers and income decreases. As
income decreases, consumers decrease consumption by ∆C=MPC*∆Y
moving down the AE curve (B-C) and also decrease savings by
∆S=MPS*∆Y moving down the savings curve B to C.
 SN=(Y-T-C)+(T-G): YS

8.2.1 Consumption:
 As discussed previously, if income is held constant
and consumers decide to spend more (C), this must
be met by an equal decrease in savings. On the other
hand, lower consumption holding income constant
must mean that the consumer is saving more.
 In previous sections we saw the following effects on
private savings:
o Income: When an individual’s income increases,
part of that increased income is saved and part of
it is consumed.↑Y→↑S & YS
o Wealth: When an individual’s wealth increases
there would be less of need to save and as a result, they will increase consumption today.
WCS
o Prices & Real Wealth: PW/PC & S
o Future Income: The more money an individual expects to have in the future the less need there is
for saving income today. Expected Future Income→↑C→↓S
 Therefore, anything other income that increases consumption will decrease savings and anything that
increases savings will decrease consumption. Although we have discussed how interest rates affect
consumption, we can build a more thorough understanding by looking at how interest rates affect
savings.
 Increase in consumption leads to an upward shift in the AE curve (A-B) and a decrease in the savings
curve (S to S’: a-b)AE>Y & S<I.
 SN=(Y-T-C)+(T-G): CS

6
 On the other hand, a decrease in consumption shifts the AE curve downward (A-B) and increases the
supply curve (a-b)AE<Y & S>I.
 SN=(Y-T-C)+(T-G): CS

8.2.1 Taxes:
 Taxes have a complex effect on national savings. The complexity is due to the fact that taxes decrease
the amount of money available for expenditures by consumers in the economy and also increase the
funds available to the government. Taxes are a transfer from private savings to public savings. From this
perspective it seems straight forward, a $1 increase in taxes reduces private savings (SPriv=Y-T-C) by
$1 and increases public savings (SPub=T-G) by $1. However, because taxes also determine the level
of consumption in the economy (C=Ca+mpc*(Y-T)) we have a third effect which must be taken into
account.
 δ =.75
 Taxes & Private Savings:
 S Priv =Y −T −C a −δ Y +δ T
Priv
 T ($1)¿ Y −T ( $ 1 ) −Ca −δ Y +δ T (.75)=S
 Private savings is reduced by .25. When the government imposes a tax of $1, private savings is
reduced by $1, but consumers reduce consumption my .75, which causes private savings to
increase by .75.
 Therefore, the net change is a reduction in private savings by .25=.75-1.
 When the government increases taxes, part of that government revenue is generated by a
reduction in savings (MPS*∆T) and the other part is financed by a reduction in savings.
 Therefore, when the government takes $1 from me, I reduce spending on goods and services
by $0.75 and give that to the government, and I also pull $0.25 out of savings and give it to
them. So overall, my savings is only decreased by $1. The decrease in my savings was based
on the fact that I save a certain potion of every dollar∆S from an increase in taxes is
∆T*MPS.
 S Priv =Y −T ( $ 1)−C a−δ Y + δ T ( $ 0.75)S by $1 & S by $0.75.
 S Priv =Y −T −C a −δ Y +δ T
∂s
 Optional: Derivative of T with respect to S =−1+δ T ¿ δ−1 mpc−1=−mps
∂T
Example 2: Taxes & Consumption
 Starting with the consumption function we have the following:
o C=Ca+mpc*(Y-T)
o Consumption equals Ca + the amount of disposable income spent (MPC*(Y-T))
 Setting δ =MPC , we have C=C a+ δ ( Y −T )
 We can also distribute δ to the bracketed terms:δ ( Y −T )=δY −δT
o C=( C a +δY −δT ) ∆C=∆ C a+ δ ∆ Y −δ ∆ T
o When only taxes change, δ ∆ Y =0 and ∆ C a=0
o This leaves the change in consumption when taxes change as: ∆C=−δ *∆T
o When taxes change, consumption changes by MPC* ∆T.
o ∆C=-MPC*∆T  ∆C=−δ *∆T
o If the MPC=0.80 and taxes change by $1∆C=-δ *∆T-0.8*1=.80C by 0.80
increases savings by 0.80

7
 Therefore, when taxes increase, consumption decreases by the MPC multiplied by the change in taxes.
Since decreases in consumption raise savings, we can state the following:
o TCS by -MPC*∆T
o TCS by -MPC*∆T

Taxes & Private Savings

o We can now combine the change in consumption with the change in private savings before adding
the effect on public savings.
o Spriv=Y-T-(C a+ δY −δ T ¿ .Distribute the negative Spriv=Y-T-C a−δY +δ T .
o - S Priv =Y −T −C a −δY + δT with repsect to private savings, we can see that when taxes increase
($1), first private savings decreases by T ($1), but then consumption also decreases by (δT ¿,
causing savings to increase by (δT ¿=(.8*1)=$0.80. Assuming that the MPC is 0.8.
o Overall, a $1 increase in taxes causes private savings to decrease by $0.20down by $1 and then up
by $0.80.
o Therefore, we can write the change in private savings as
 ∆ Spriv=δ ∆ T −∆ T
 ∆ Spriv=δ ∆ T −∆ T =0.8∗1−1=−0.20
 Therefore, higher taxes decrease private savings by 0.20.
o If taxes had decreased by $1, we would have the following:
 ∆ Spriv=δ ∆ T −∆ T =0.8∗−1−(−1 ) =−0.8+1=0.20
o Before continuing, we can make one more adjustment to the change private savings equation.
 ∆ Spriv=δ ∆ T −∆ T .Factor out the common term ∆T∆ Spriv=∆ T ( δ−1 )
o As we know, ( δ −1 )=( MPC−1)we also know that 1-MPC=MPSMPC=1-MPS
 ( MPC−1)=((1-MPS)-1)=-MPS ∆ Spriv=∆ T (−MPS ) . Therefore, the change in private
savings is simply the change in taxes multiplied by -MPS.
 From the above example, the MPC is 0.8, which means the MPS is 0.2. From our equation, the
change in private savings should be ∆ Spriv=∆ T (−MPS ) 1*-0.2=-0.2.
 As we can see, the change in private savings when taxes change is ∆T*-MPS.

Taxes & National Savings

 We can now include the effects on public savings. As stated, public savings increases 1 for 1 with taxes:
S Pub =T −GT ($1) leads to an increase in public savings by $1.
 Bringing together private and public savings, we have the following effect of changes in taxes:
o Taxes
 Private savings by -MPS
 Public Savings by ∆T
o Overall effect:
 ∆ SN=∆Spub+∆Spriv ∆ SN=∆T+(-∆T*MPS) ∆ SN=∆T(1-MPS) ∆
N
S =∆T*MPC
 TS by ∆T*MPC
 TS by ∆T*MPC

8
 N
 S =(Y −T −( Ca + δY −δT ) )+ ( T−G )
N
 ∆ S =∆ Y −∆ T −∆ C a−∆ δY + ∆ δT +∆ T −∆G
 ∆Y, ∆ C a, ∆ δY , and ∆ G all equal zero as they did not change.
 ∆ S N =0−∆ T −0−0+∆ δT + ∆ T −0
 ∆ S N =−∆ T +∆ δT + ∆ T
 ∆ S N =∆ δT
 Therefore, higher taxes increase national savings by the MPC and lower taxes reduces national
savings by the MPC.

Example Change in National Savings

 Assume G=0, T=0, C a=150, δ =.60 , and Y=1000. Assume taxes increase by $55.
 Initial Savings:
o S N =Y −T −C a−δY +δT +T −G
o S N =1000−0−150−0.60 ( 1000 ) +0+ ( 0−0 )=1000−150−600=250
o Total income in the economy is 1000 which is spent on consumption (750) and savings
(250).
 After Tax:
o S N =Y −T −C a−δY +δT +T −G
o S N =1000−(55)−150−0.60 ( 1000 ) +0.60(55)+ ( 55−0 )=283
o An increase in taxes of $55 leads to an increase in national savings by 33.
 Using Equations:
 ∆ S N =∆ δT =0.6*55=33
 or
 ∆ Spriv=∆ T (−MPS )=55∗−.4=−22
 ∆ Spub=∆ T =55
 ∆ S N =∆ Spriv+∆ Spub=-22+55=33 or
 ∆ S N =∆ δT =0.6*55=33
 As we can see, the increase T to the government comes from two sources: reduction in private savings
and a reduction in consumption.
 In other words, taxes are financed by reducing private savings and reducing consumption. Part of the
increase in public savings is simply transfer from private to public savings, the rest of the tax comes
from a decrease in consumption.
 TS
 TS
 Increase in taxes reduces AE shifting the AE curve downward (A-B) through a reduction in
consumption and increase savings by ∆T*MPC shifting he Savings curve upward (S-S’: a-b). This leads
to AE<Y and S>I. It will be followed by the multiplier effect.

9
 On the other hand, a decrease in taxes increases the AE shifting it upward (A-B) and decreases national
savings by the MPC shifting the savings curve downward (a-b). This leads to AE>Y and S<I. This will
be followed by the multiplier effect.

8.2.1 Interest Rates

 Although we have discussed how interest rates affect consumption, we can build a more thorough
understanding by looking at how interest rates affect people’s choice to save.
 An increase in interest rates always offers a higher incentive to people to save more (higher return). As
interest rate increase, savers earn a higher return and thus, would want to save more. On the other hand,
a decrease in interest rates lowers the return to savings causing people to want to save less.
 Therefore, all individuals regardless of whether they are a lender (saver) or borrower, will have an
incentive to save more.
 This decision to save based on the return to savings is known as the substitution effect.
o Substitution Effect:
 iReturn on SavingsC & S
 iReturn on SavingsC & S
 Although the substitution effect shows a positive relationship between the interest rate and savings,
there is a secondary effect on savings from changes in the interest rate.
 This effect, known as the income effect, represents the change in the level of income to the consumer
from changes in the interest rate. Since changes in the interest rate affect savers and borrowers
differently, the income effect is different for each group.
Borrowers:
 Income Effect: The increase in the interest rate increases borrowers interest payments which means
debt financed consumption becomes more expensive. As a result, consumers who finance consumption

10
 through borrowing will decrease their consumption when interest rates increase causing savings to
increase.
 iC & S
 Therefore, for borrowers both the substitution and income effects lead to lower consumption and higher
savings when interest rates increase.
Savers:
 Income Effect: The increase in the interest rate leads to higher interest income for savers allowing them
to save less to meet their future consumption needs. As such, an increase in the interest rate leads to
lower savings and higher consumption based on the income effect.
 iC & S
 Overall Effect: For savers, both the substitution and income effects on consumption and savings offset
each other. Therefore, the effects of a higher interest rate on savings and consumption for savers
depends on which effect is stronger (income Borrower Savers
or substitution). Substitution Effect iS iS
 As such, economic theory does not provide an Income Effect iCS iS
answer to whether aggregate savings increases Overall iS i S or S
or decreases when interest rates increase.
However, from the empirical evidence and research, it is generally seen that higher interest rates lead to
lower consumption and higher savings. This corresponds to the connection we made earlier with respect
to consumption and the interest rate.
o iC & S
o iC & S
 Looking at the following graph we see that higher interest rates reduce the AE curve (shifting it down)
through the reduction in consumption. At the same time, the higher
interest rates increase savings shifting the savings curve upward (S-
S’). This leads to AE<Y and S>I, which will then cause the
multiplier effect.
 If interest rates decreased, the AE curve would shift upward, and the
Savings curve would shift downward leading to AE>Y and S<I.
 It is important to note that changes in interest rates also affect
investment. This would be included in the AE shift. Higher interest
rates reduce consumption and investment, and lower interest rates
increase both consumption and investment. Although it does not
change the analysis in the AE model by including investment
changes, in the bottom graph, the decrease in investment would
shift the Investment curve downward. Again, it would not change
the conclusions of AE<Y or S>I, it would add to the magnitude of
the shifts in the curve.

8.2.2 Summary for Savings:

 Assume an individual has a desired amount they want to have in future consumption.
 Income: When an individual’s income increases, part of that increased income is saved and part
of it is consumed.↑Y→↑S & YS
 Consumption: CS & CS

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  Taxes: TaxesSavings TaxesSavings
 Interest rate: iS & iS
 Government Spending: Higher government spending reduces public savings and with no change
in tax policy will decrease national savings. Lower government spending will increase national
savings.
Factors Affecting Savings
Government G S Less income for savings
National Savings G S More income for savings
Spending
C S
Consumption
C S
T S SPub>SPriv
Taxes
T S SPub>SPriv
i S
Interest Rate i S

8.2.2 Review of Investment:

 Investment & Interest Rate: Keynes considered the cost of borrowing to be the key factor in
determining planned investment. Although the level of investment in the economy depends on many
different variables, the primary variable affecting the level of investment by firms, households and the
government is the cost of borrowing funds.
o The real interest rate represents the cost of borrowing funds for firms. If firms are using
retained earnings (profits) to finance investment, then the real interest rate will represent
the opportunity cost of those funds.
o A rise in the real interest rate will decrease the number of investment projects that yield a
positive return to the firm and will cause a decrease investment.
o Also, a rise in the real interest rate will cause an increase in the opportunity costs of funds
and lead to a higher required return on investments for shareholders, which again
decreases the number of potential profitable investments.
o Finally, higher real interest rates will lead to a reduction in the number of new homes
purchased as the cost of borrowing has increased (interest payments).
o Economic agents will borrow funds for investment when the benefits of the investment
project are greater than the costs of acquiring the funds because the transaction will lead
to increased profit and utility.
o As long as the benefits are greater than the costs, the agent will borrow the funds to
invest. Since the real interest rate measures the cost of borrowing, when the interest rate
rises, the cost of borrowing increases and some investments that were previously
profitable will no longer be profitable and agents will decrease their level of investment.
On the other hand, a decrease in the interest rate will lead to some projects that were not
previously profitable, to become profitable, and as a result, agents will increase
investment.
 rI & rI
 As shown below, if r* is the equilibrium interest rate, then all points above G
represent potential transactions where the rate of return is greater than the
cost of acquiring funds. Below the point G, the rate of return on capital is less

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 than the cost acquiring funds. As such, firms would lose profit if they engaged these potential
transactions. Therefore, firms will investment in capital up to the point where the rate of return equals
the cost of acquiring funds (interest rates).
o r (G-H)Cost of BorrowingLess Profitable InvestmentsInvestment
o r (G-J)Cost of BorrowingMore Profitable InvestmentsInvestment
 Interest Rate:
o rCost of BorrowingLess Profitable r
r3 B
InvestmentsInvestment
A
r2

r
rCost of BorrowingMore Profitable
r1
o r3
I

I'' I I
InvestmentsInvestment
A
r2

B
r1
I

I I'' I
The following factors will shift the Investment Curve:
r
r r3
r3

A
B r2
r2 B
A

r1
r1 I
I I''
I''
I I

(Increases in Investment (not from changes in r)).

(Decreases in Investment (not from changes in r))
 MPK:
o MPK (Positive Shocks)Inv
o MPK (Positive Shocks)Inv
o Expected Future Output or Positive ShockMPK
o Expected Future Output or Negative ShockMPK
 Expectations:
o Like consumption, Keynes believed there was a part of investment not explained by
interest rates. This part of investment is based on expectations about the economy. If
firms believe the economy will expand, they expect future profits to be higher and
increase investment. On the other hand, if firms believe that we are heading into a
recession, they will probably decrease investment. This provides an indirect link to
output/income. Higher outputhigher salesexpected future higher profitInv.
However, we assume no relationship between current output and investment to keep
things somewhat simple.
 Taxes:
o Higher taxes reduce the after-tax profit to firms from investment projects. As a result,
firms will require a higher rate of return. Therefore, some projects that were profitable
before the increase in taxes are no longer profitable and as such, firms decrease their level
of investment.
 Cash Flow:

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 o Higher profits lead to greater cash flows, which allows firm to finance greater
investment.
 Investment Function:
o I =I A−dr c
 d=responsiveness of investment to changes in the real interest rate/real cost of
borrowing.
 rc=real cost of borrowing
 IA=investment based on expectations about the economy and includes shocks to
the MPK.
o r c =r+ f
 r=real interest rate on default free debt instruments.
 f=financial frictions. Additions to the real cost of borrowing due to asymmetric
information’s in the financial markets.
o I =I A−d∗(r +f )
 Investment is positively related to business optimism, positive shocks to MPK
(IA), negatively related to the real interest rate and financial frictions.

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