Changes in the demand for or the supply of financial capital lead to
changes in the equilibrium interest rate and levels of investment and
saving. Part (i) illustrates an increase in the supply of saving. As
households decide to increase the amount of their saving (at any given
interest rate), the excess supply of capital leads to a reduction in the
interest rate, from to. As the interest rate falls, firms increase their
quantity of investment demanded. The equilibrium level of investment
(and saving) increases from to.
Part (ii) illustrates an increase in investment demand. As firms decide to
increase their desired investment, they require more financial capital (at
any given interest rate). This leads to an excess demand for capital and to
an increase in the interest rate, from to. As the interest rate rises,
households decide to increase their desired saving. The equilibrium level
of investment (and saving) increases from to.
- Income Growth
As income increases, households desire to consume more, both now and
in the future. The greater income leads to an increase in households’
desired saving and thus to an increase in the supply of financial capital.
Gradual but ongoing income growth over a period of many years is an
i 1 i 2
I 1 I 2i 1 i 3
I 1 I 3