Page 49 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Saving is the leakage out of the spending stream. Investment is the injection into the spending
stream. So long as the leakages (S) equal injections (I), AS will be equal to AD, and the product
market will be in full employment equilibrium.
In the classical model, adjustments in the real rate of interest in the capital market ensure
equality of saving and investment.

3.2.3 Capital Market Equilibrium

Generally speaking, capital market refers to the borrowing and lending activities of the financial
institutions. It is the market in which there are suppliers of funds and demanders of funds. It is
also called loanable funds market. The price at which the funds are lent and borrowed is rate of
interest. In the classical model, it is the real rate of interest.
The capital market is in equilibrium at that 'real rate of interest' (real ROI) at which the supply
of funds (saving) equals demand for funds (investment).

Real ROI and Saving

Saving is a function of disposable income and real ROI. In the classical model, disposable
income is full employment income and is fixed. With disposable income fixed saving depends
on real ROI. How does saving behave as ROI changes?
A change in real ROI has income effect (IE) and substitution effect (SE). Suppose real ROI rises.
The two effects are:
IE: Real ROI rises. Income from interest rises. Since income rises consumption rises. Since
consumption rises, saving falls.

SE: Real ROI rises. Opportunity cost of saving rises. Consumption falls. Saving rises.
The two effects work in opposite directions. The evidence suggests that IE and SE offset each
other. This makes the saving curve a vertical straight line (Figure 3.8)

Figure 3.8
Y
Real
R/I IE=SE
S

X
O Saving

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