[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

est rate (perhaps rising slightly with it). For the sake of simplicity, then, we will often
assume saving is completely inelastic—that is, it does not change at all as the real
interest rate varies. In this case, changes in the real rate of interest do not lead to any
change in saving. This results in a vertical saving function, as shown in Figure 24.7.
The assumption that saving does not respond to changes in the real interest rate
might seem to be inconsistent with one of our key economic concepts—that incentives
matter. Because a rise in the real rate of interest provides a greater incentive
to save, it should lead to an increase in household saving. However, an offsetting
income effect works in the opposite direction. If the adults in a household are saving
for the college expenses of their children or for their own retirement, a higher real
rate of interest means that they need to save less each year to reach their goal in
the future. For example, suppose you want to have $15,000 saved up in ten years. If
the real rate of interest is 2 percent, you must save $1,370 annually; if the real rate
of interest rises to 10 percent, the amount needed each year drops to $941.25. You can
reduce your current level of saving and still achieve your goal of $15,000. The income
effect of a rise in the real rate of interest works to reduce saving, while the substitution
effect of a rise in the real interest rate, the direct incentive effect of the higher
return, acts to increase saving. The two effects pull in opposite directions, and the
evidence suggests that the result is essentially a draw. That is why household saving
is not very sensitive to the real interest rate and why we will often assume it is
completely inelastic.
INVESTMENT
Economists use the word investment in two different ways. Households think of the
stocks and bonds they buy as investments—financial investments. These financial
investments provide the funds for firms to buy capital goods—machines and
buildings. The purchases of new machines and buildings represent firms’ investment,
referred to as capital goods investment or simply as investment. In macroeconomics,
when we refer to investment, it is to physical investment in capital goods, not
financial investment.
Firms invest to increase their capacity to produce goods and services. They
expect returns from the sales of this additional production to cover the costs of the
additional workers and raw materials required, as well as the cost of the funds that
financed the investment, leaving the firm with a profit.
There are two key determinants of investment: firms’ expectations concerning
future sales and profits, which for now we will assume to be fixed, and the real rate
of interest. Many firms borrow to finance their investment. The cost of these funds—
what they have to pay back to the financial sector for using the borrowed funds—is
the interest rate. Since the firm pays back a debt with dollars whose purchasing
power depends on inflation, the relevant cost is the real rate of interest.
The higher the real rate of interest, the fewer the investment projects that will
be profitable—that is, the fewer the projects that will yield a return sufficient to
compensate the firm for the risks undertaken after interest on the borrowed funds
is paid back. Even if the firm is flush with cash, the interest rate matters. The real
interest rate then becomes the opportunity cost of the firm’s money—that is, what
REAL INTEREST RATE (r )
Figure 24.7
Investment
function
INVESTMENT (I )
Saving
function
THE SAVING FUNCTION AND
THE INVESTMENT FUNCTION
If saving is unresponsive to the real interest
rates, then the saving function will be
vertical. The investment function slopes
downward to the right, tracing out the
levels of real investment at different real
interest rates. As the interest rate falls,
investment increases.
THE CAPITAL MARKET ∂ 537