Saving, Investment, and Economic Growth

Savings in the economy are supplied by households, firms, and the government and demanded by firms wanting to invest in new capital goods. Together, the demand and supply of savings determine the real interest rate and the level of investment in the economy in the long run. Changes in the demand for savings or supply of savings change the interest rate and level of investment, and ultimately the level of economic growth. Therefore, understanding the factors that affect the demand and/or supply of savings helps us to explain changes in economic growth and the long-run effects of government policies that affect saving and/or investment decisions in the economy.

Exploration: How do changes in government policy and changes in technology affect real interest rates and investment in the economy?

The applet above illustrates the supply of and demand for savings in the economy. The long-run equilibrium interest rate and level of investment are determined by the intersection of the S and I curves. To use the graph, use the mouse to drag the I or S labels to the right or left and click on the New Equilibrium button to observe the movement to the new equilibrium. Click the Update button to refresh the curves to their current positions and click the Reset button to restore the curves to their original positions.

1. Before working with the applet for this exercise, think about how an increase in technology will affect the demand for and supply of savings. Will a change in technology affect the demand for savings? Will it affect the supply of savings? In what way will it affect the demand or supply of savings?
   
   
2. What will be the effect of an increase in technology on the real interest rate and the amount of saving and investment in the economy? What happens to the real interest rate, the level of saving, and the level of investment at the new equilibrium? Why? What are the likely long-run economic effects from the increase in technology?
   
   
3. The U.S. federal budget deficit grew during the early 2000s due to an economic recession, increased homeland security in response to the September 11, 2001 terrorist attacks, a U.S.-led war in Iraq, and tax reduction legislation passed in the spring of 2003. How does an increase in the federal government's budget deficit affect the demand for and supply of savings in the market for savings? Will the increased budget deficit affect the demand for savings? Will it affect the supply of savings? In what way?
   
   
4. What is the effect of an increase in the government's budget deficit on the real interest rate and the amount of saving and investment in the economy? What are the likely long-run economic effects from the increased budget deficit?
   
   
5. What would be the effect on the real interest rate and the level of investment of government legislation that eliminated income tax on interest earned from savings accounts?
   
   
6. What would be the effect on the real interest rate and the level of investment of government legislation that reduced income taxes for firms that invested more money in new capital?

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