For the goods market to be in equilibrium, then, the aggregate supply of goods must equal the aggregate demand for goods, or equivalently, desired national saving must equal desired investment. We demonstrate in this section that adjust-ments of the real interest rate allow the goods market to attain equilibrium.15
14We assume that G always equals the level desired by the government and so we don’t distinguish between desired and actual G.
15Strictly speaking, we should refer to the expected real interest rate rather than simply the real interest rate. The two are the same if expected inflation and actual inflation are equal.
ChaPter 4 | Consumption, Saving, and Investment 137
The determination of goods market equilibrium can be shown graphically with a saving–investment diagram (Figure 4.8). The real interest rate is measured along the vertical axis, and national saving and investment are measured along the horizontal axis. The saving curve, S, shows the relationship between desired national saving and the real interest rate. The upward slope of the saving curve reflects the empirical finding (Section 4.1) that a higher real interest rate raises desired national saving. The investment curve, I, shows the relationship between desired investment and the real interest rate. The investment curve slopes down-ward because a higher real interest rate increases the user cost of capital and thus reduces desired investment.
Goods market equilibrium is represented by point E, at which desired na-tional saving equals desired investment, as required by Eq. (4.8). The real inter-est rate corresponding to E (6% in this example) is the only real interinter-est rate that clears the goods market. When the real interest rate is 6%, both desired national saving and desired investment equal 1000.
How does the goods market come to equilibrium at E, where the real inter-est rate is 6%? Suppose instead that the real interinter-est rate is 3%. As Fig. 4.8 shows, when the real interest rate is 3%, the amount of investment that firms want to undertake (1500) exceeds desired national saving (850). With investors wanting to borrow more than savers want to lend, the “price” of saving—the real interest rate that lenders receive—will be bid up. The return to savers will rise until it reaches 6%, and desired national saving and desired investment are equal. Similarly, if the real interest rate exceeds 6%, the amount that savers want to lend will exceed what investors want to borrow, and the real return paid to savers will be bid down. Thus adjustments of the real interest rate, in response to an excess supply or excess demand for saving, bring the goods market into equilibrium.
FIgure 4.8
goods market equilibrium Goods market equi-librium occurs when desired national saving equals desired invest-ment. In the figure, equilibrium occurs when the real inter-est rate is 6% and both desired national saving and desired investment equal 1000. If the real interest rate were, say, 3%, desired investment (1500) would not equal desired national saving (850), and the goods market would not be in equilibrium. Competition among borrowers for funds would then cause the real interest rate to rise until it reaches 6%.
Real interest rate, r
Desired national saving, Sd, and desired investment, Id
850 1000 1500
6%
3%
Investment curve, I Saving curve, S
E
138 Part 2 | Long-Run Economic Performance
Although Fig. 4.8 shows goods market equilibrium in terms of equal saving and investment, keep in mind that an equivalent way to express goods market equi-librium is that the supply of goods, Y, equals the demand for goods, Cd + Id + G (Eq. 4.7). Table 4.3 illustrates this point with a numerical example consistent with the values shown in Fig. 4.8. Here the assumption is that output, Y, and government purchases, G, are fixed at values of 4500 and 1500, respectively. Desired consump-tion, Cd, and desired investment, Id, depend on the real interest rate. Desired con-sumption depends on the real interest rate because a higher real interest rate raises desired saving, which necessarily reduces desired consumption. Desired investment depends on the real interest rate because an increase in the real interest rate raises the user cost of capital, which lowers desired investment.
In the example in Table 4.3, when the real interest rate is 6%, desired consumption Cd = 2000. Therefore desired national saving Sd = Y - Cd - G = 4500 - 2000 - 1500 = 1000. Also, when the real interest rate is 6%, desired investment Id = 1000. As desired national saving equals desired investment when r = 6%, the equilibrium real interest rate is 6%, as in Fig. 4.8.
Note, moreover, that when the real interest rate is at the equilibrium value of 6%, the aggregate supply of goods, Y, which is 4500, equals the aggregate demand for goods, Cd + Id + G = 2000 + 1000 + 1500 = 4500. Thus, both forms of the goods market equilibrium condition, Eqs. (4.7) and (4.8), are satisfied when the real interest rate equals 6%.
Table 4.3 also illustrates how adjustments of the real interest rate bring about equilibrium in the goods market. Suppose that the real interest rate initially is 3%.
Both components of private-sector demand for goods (Cd and Id) are higher when the real interest rate is 3% than when it is 6%. The reason is that consumers save less and firms invest more when real interest rates are relatively low. Thus, at a real in-terest of 3%, the demand for goods (Cd + Id + G = 2150 + 1500 + 1500 = 5150) is greater than the supply of goods (Y = 4500). Equivalently, at a real interest rate of 3%, Table 4.3 shows that desired investment (Id = 1500) exceeds desired saving (Sd = 850). As Fig. 4.8 shows, an increase in the real interest rate to 6% eliminates the disequilibrium in the goods market by reducing desired investment and in-creasing desired national saving. An alternative explanation is that the increase in the real interest rate eliminates the excess of the demand for goods over the supply of goods by reducing both consumption demand and investment demand.
Shifts of the Saving Curve. For any real interest rate, a change in the economy that raises desired national saving shifts the saving curve to the right, and a change that reduces desired national saving shifts the saving curve to the left.
(Summary table 5 on p. 120 lists the factors affecting desired national saving.) tabLe 4.3
Components of aggregate Demand for goods (an example)
Real interest
Rate, r output, Y
Desired consumption, Cd
Desired investment, Id
Government purchases, G
Desired national saving, Sd = Y − Cd − G
Aggregate Demand for Goods, Cd + Id+ G
3% 4500 2150 1500 1500 850 5150
6% 4500 2000 1000 1500 1000 4500
ChaPter 4 | Consumption, Saving, and Investment 139
A shift of the saving curve leads to a new goods market equilibrium with a dif-ferent real interest rate and difdif-ferent amounts of saving and investment. Figure 4.9 illustrates the effects of a decrease in desired national saving—resulting, for exam-ple, from a temporary increase in current government purchases. The initial equi-librium point is at E, where (as in Fig. 4.8) the real interest rate is 6% and desired national saving and desired investment both equal 1000. When current government purchases increase, the resulting decrease in desired national saving causes the saving curve to shift to the left, from S1 to S2. At the new goods market equilibrium point, F, the real interest rate is 7%, reflecting the fact that at the initial real interest rate of 6% the demand for funds by investors now exceeds the supply of saving.
Figure 4.9 also shows that, in response to the increase in government pur-chases, national saving and investment both fall, from 1000 to 850. Saving falls because of the initial decrease in desired saving, which is only partially offset by the increase in the real interest rate. Investment falls because the higher real inter-est rate raises the user cost of capital that firms face. When increased government purchases cause investment to decline, economists say that investment has been crowded out. The crowding out of investment by increased government purchases occurs, in effect, because the government is using more real resources, some of which would otherwise have gone into investment.
Shifts of the Investment Curve. Like the saving curve, the investment curve can shift. For any real interest rate, a change in the economy that raises desired in-vestment shifts the inin-vestment curve to the right, and a change that lowers desired investment shifts the investment curve to the left. (See Summary table 6 on p. 132 for the factors affecting desired investment.)
The effects on goods market equilibrium of an increase in desired investment—
as from an invention that raises the expected future marginal product of capital—are FIgure 4.9
a decline in desired saving
A change that reduces desired national saving, such as a temporary increase in current government purchases, shifts the saving curve to the left, from S1 to S2. The goods market equilib-rium point moves from E to F. The decline in desired saving raises the real interest rate, from 6% to 7%, and lowers saving and investment, from 1000 to 850.
Real interest rate, r
Desired national saving, Sd, and desired investment, Id 850 1000
6%
7%
I S2
E F
S1
140 Part 2 | Long-Run Economic Performance
shown in Figure 4.10. The increase in desired investment shifts the investment curve to the right, from I1 to I2, changing the goods market equilibrium point from E to G. The real interest rate rises from 6% to 8% because the increased demand for investment funds causes the real interest rate to be bid up. Saving and investment also increase, from 1000 to 1100, with the higher saving reflecting the willingness of savers to save more when the real interest rate rises.
FIgure 4.10
an increase in desired investment
A change in the economy that increases desired investment, such as an invention that raises the expected future MPK, shifts the investment curve to the right, from I1 to I2. The goods market equilibrium point moves from E to G. The real interest rate rises from 6% to 8%, and saving and investment also rise, from 1000 to 1100.
Real interest rate, r
Desired national saving, Sd, and desired investment, Id 1000
6%
8%
I1 E
G S
1100
I2