Monday, April 25, 2011

Induced Investment and Thriftiness

In the topic Autonomous Investment and Thriftiness we have assumed that investment is independent of national income. That is not true. The investment schedule is not a straight line parallel to the X-axis. In reality entrepreneurs undertake more investment if sales and profit prospects improve. Thus they are induced to make more investments to satisfy the growing demand that influences the market. Even in the short run, the investment schedule takes the shape of a rising curve. More investment will generate more income and employment. Opportunities will increase, and producers will be induced to invest and produce more.

If we introduce induced investment with thriftiness the situations becomes worse than what it is with autonomous investment.

IpIp is the induced investment curve. It depends on the rate of change of GNP (Gross National Product). So the induced investment function is upward sloping. Ip stands for induced private investment. SS is the initial savings function, which cuts the induced investment function IpIp at E. An increase in thriftiness means an upward shift of the savings function SS to S'S'. F becomes the new equilibrium point. This corresponds to a lower level of income, OYf.
1. Aggregate savings goes up by ΔS.

2. As a result, national income falls by -ΔY.

3. Consequently, savings and investment will also fall from S = I to S' = I'.

An increased desire to save leads to a fall in savings due to a fall in income.

The Paradox of Thrift

Thus the policy of thriftiness is self-defeating. People want to save more but due to a fall in income, the savings also comes down. An increase in thriftiness leads to a fall in income, since the multiplier process acts in the negative direction. This leads to a fall in savings. So the society, at the end, saves less, not more.

Must also read: Autonomous Investment and Thriftiness

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