2.1.7 Analysis of consumption, saving and investment and their interaction in a simple economic model

In a simple economic model, consumption, saving, and investment are essential components that interact to determine the overall level of economic activity and growth. Let’s analyze each of these components and their interactions:

1. Consumption: Consumption refers to the spending by households on goods and services for their satisfaction and well-being. It includes purchases of items like food, clothing, housing, entertainment, and healthcare. In a simple economic model, consumption is influenced by factors such as disposable income, consumer preferences, and the level of consumer confidence.

The consumption function represents the relationship between disposable income and the level of consumption. It is often assumed that as disposable income increases, consumption also increases, but at a decreasing rate. This is known as the marginal propensity to consume (MPC). It indicates the fraction of additional income that households spend on consumption. For example, if the MPC is 0.8, it means that for every additional unit of income, households spend 80% of it on consumption.

2. Saving: Saving is the portion of income that households do not spend on consumption. It represents the amount of money set aside for future needs or investments. In a simple economic model, saving is influenced by disposable income, interest rates, and consumer preferences for current versus future consumption.

The saving function represents the relationship between disposable income and saving. As disposable income increases, saving also tends to increase. The marginal propensity to save (MPS) is the fraction of additional income that households save. It is the complement of the MPC, meaning MPS + MPC = 1.

3. Investment: Investment, in the context of a simple economic model, refers to the spending by businesses on capital goods, such as machinery, buildings, and technology, with the aim of increasing production and future economic growth. Investment is influenced by factors such as interest rates, business expectations, and the level of economic activity.

The level of investment in an economy is also related to the level of saving. When households save, banks and financial institutions have funds available to lend to businesses for investment projects. This relationship between saving and investment is known as the savings-investment identity:

Total Saving = Total Investment

This identity shows that in a closed economy (where there are no international transactions), the total amount saved by households is equal to the total amount invested by businesses.

Interactions in the Simple Economic Model: In a simple closed economy, the interactions between consumption, saving, and investment are interconnected and determine the level of economic activity and equilibrium. When households consume, it drives demand for goods and services, leading to production and income for businesses. Some of this income is saved, and the rest is spent on consumption or investment.

At equilibrium, total saving in the economy is equal to total investment, which means that all available savings are being used for investment purposes. If total saving exceeds total investment, there is a surplus of savings, which may lead to reduced interest rates and increased investment. Conversely, if total investment exceeds total saving, there is a shortage of savings, leading to higher interest rates and reduced investment.

In this simple economic model, changes in consumption, saving, or investment can have multiplier effects on economic activity. For example, an increase in investment can lead to increased production and employment, which, in turn, can boost household income and consumption.