Economic development of a country refers to an increase in the standard of living of its people coupled with a sustained growth rate. Today we are going to discuss in brief about the concepts of consumption, savings and investment and also line out the relationship between these three variables according to the classical system.
Consumption, Savings and Investment
The main hypothesis of Keynes suggested that our disposable income which can be arrived at by deducing tax liabilities from gross income influences our level of real consumption. Further explanation on this is
C = f (Y) where C stands for consumption and Y stands for disposable income.
Keynes also held the view that people tend to enhance their consumption level along with a rise in their disposable income.
However, the increase in disposable income is greater than the increase in consumption. This hypothesis can be termed as our marginal propensity to consume and indicates a positive correlation between these two variables.
This, if our income increases by one unit, our marginal propensity to consume increases by 0.8 units. Hence the remaining 0.2 units are used for savings.
Y = C + S where Y stands for disposable income, C stands for consumption and S stands for savings.
It is also imperative to note here that propensity to consume and desire to consume are not similar in nature as the former means effective consumption.
Both objective and subjective factors influence our consumption function. Tax policy, interest rate, windfall profit or loss and holding of assets are some objective functions whereas subjective ones relate to motives of foresight, precaution, avarice, and improvement amongst individuals.
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Learn more about National Income here in detail
In plain words, savings refer to the excess of disposable income over consumption expenditure.
From a national level, the unconsumed part of the entire nation’s income comprising of all its members can be termed as National Savings.
Total domestic savings, on the other hand, can be defined as the summation of savings of the government, the business sector, and households.
Some of the biggest determinants of savings are
- Income, as saving income ratio holds a proportionate relation with the rise in income. People also have a tendency of saving the excess part of their income but not the entire bulk.
- Distribution of income as the savings process is helped to a great extent by inequality of income distribution. Our desire to showcase a superior standard of living in comparison to our neighbors often steers us towards purchasing expensive goods which in turn declines the level of savings.
- Psychological or subjective factors such as savings to safeguard ourselves from future insecurity and uncertainty. The ultimate attitude of people is driven towards savings by their farsightedness. This, in turn, boosts them up to enjoy a better standard of living both for themselves and their loved ones.
- Prevalent financial instruments and rate of interest as a higher rate motivates greater savings.
Definition of Investment is:
- Change in capital stocks or inventories pertaining to a business venture between two different periods or
- Production of fresh capital goods such as plants and equipment.
Relation Between Savings and Investment In Classical System
According to this theory, Savings (S) gets equated with Investment (I) automatically which otherwise alters the interest rate. If savings exceeds investment, the excess supply of funds brings down the rate of interest.
This, in turn, reduces savings and increases investment for maintaining equilibrium.
However, this law of the market holds good when the entire amount of savings is invested.
Questions Consumption, Savings and Investment
- Savings is a form of _______.
- Keynes hypothesis suggests that people tend to enhance their _____ along with an increase in their disposable income.
Ans. Consumption level