How Investments Affect Long-Term Savings Goals

Classical economics posits that interest rates adjust to equate saving and investment, avoiding a pile-up of inventories (general overproduction). A rise in saving would cause a fall in interest rates, stimulating investment, hence always equating saving and investment. However, John Maynard Keynes argued that neither saving nor investment was very responsive to interest rates, so large interest rate changes were needed to re-equate them after one changed. He also believed that the demand for and supply of money determined interest rates in the short run, and that saving could exceed investment for significant amounts of time, causing a general glut and a recession.

In personal finance, saving generally specifies low-risk preservation of money, as in a deposit account, versus investment, which carries a higher risk. Saving does not automatically include interest, and it refers to an activity occurring over time, a flow variable, whereas savings refers to something that exists at any one time, a stock variable.

In economics, saving is defined as after-tax income minus consumption. The rate of saving is directly affected by the general level of interest rates. The capital markets equilibrate the sum of (personal) saving, government surpluses, and net exports to physical investment.

When it comes to saving and investing, time matters. Money you need soon generally shouldn't be in the stock market. The money you're investing long-term – such as for retirement – probably shouldn't be in a plain old savings account. Despite a string of rate hikes from the Federal Reserve in 2022 and 2023, the average rate of return for savings accounts is still relatively low compared to that of the stock market.

Classical economics and the role of interest rates

According to classical theory, saving and investment are functions of the interest rate. When the interest rate rises, saving increases while investment decreases, and vice versa. This relationship is expressed algebraically as S = f(R) and I = f(R), where S is saving, I is investment, and R is the interest rate. At a full employment equilibrium, saving equals investment (S = I).

The classical view holds that any inequality between saving and investment can be rectified through adjustments in the interest rate. For instance, if saving is less than investment, a rise in the interest rate will lead to a decline in investment and an increase in saving until they are once again equal. Conversely, when saving exceeds investment, a decrease in the interest rate will lead to higher investment and lower saving, restoring equilibrium.

This mechanism is crucial in classical economics as it helps prevent a pile-up of inventories, also known as general overproduction. A rise in saving, for instance, would cause a fall in interest rates, stimulating investment and thereby maintaining the balance between saving and investment.

However, it is important to note that this classical perspective has been challenged by economists like John Maynard Keynes, who argued that saving and investment are not as responsive to interest rate changes as classical theory suggests. Instead, Keynes proposed that changes in income play a more significant role in bringing about equality between saving and investment.

In summary, classical economics attributes a significant role to interest rates in maintaining economic equilibrium by adjusting saving and investment. While this theory provides a framework for understanding economic dynamics, subsequent economists have offered alternative viewpoints, highlighting the complex and multifaceted nature of economic behaviour.

The impact of income on investment

Income has a significant impact on investment, and this relationship is a key aspect of both classical and Keynesian economic theories.

Firstly, income influences the level of savings an individual or entity has available for investment. A higher income provides more funds that can be directed towards investment opportunities. This increased capital can then be allocated across various investment options, such as stocks, bonds, real estate, or business ventures.

Income also affects the expected course of future income and anticipated consumption, which in turn impacts investment decisions. Individuals with higher incomes may have a more positive outlook on future income streams, encouraging them to allocate a larger proportion of their current income towards investments.

From a classical economic perspective, the rate of interest plays a pivotal role in determining the relationship between income and investment. Classical theory posits that savings are a direct function of the rate of interest, and investment is an inverse function. When income recipients become more thrifty, they save a larger portion of their income, which can then be channelled into investment opportunities.

However, Keynes critiqued the classical view, arguing that changes in income, rather than interest rates, are the primary driver of equality between savings and investment. He proposed two views: accounting or definitional equality, and functional equality. In the former, savings and investment are always equal because they are different aspects of the same thing—the excess of current income over current consumption. In the latter, savings and investment are equal only at the equilibrium level of income, where they are not only equal but also in equilibrium.

Income also influences the types of investment opportunities available to individuals. Those with higher incomes may have access to a broader range of investment options, including those that require larger initial capital outlays or those that offer potentially higher returns but carry greater risk.

Additionally, income can impact the risk tolerance of investors. Individuals with higher incomes may be more comfortable taking on riskier investments, as they can absorb potential losses more easily. Conversely, those with lower incomes may seek out more conservative investment options to protect their capital.

In summary, income plays a crucial role in shaping investment decisions and opportunities. It determines the funds available for investment, influences the outlook on future income, and interacts with interest rates to shape savings and investment behaviour. The dynamics between income and investment are further nuanced by the theories proposed by Keynes, which highlight the complex interplay of factors affecting savings and investment equality.

Savings and investment equality

Classical economics posits that interest rates adjust to equate savings and investments, avoiding an inventory pile-up. A rise in savings would cause a fall in interest rates, stimulating investment, and vice versa.

However, John Maynard Keynes disagreed with this view, arguing that neither savings nor investment was very responsive to interest rates. He believed that changes in income brought savings and investments to equality, rather than interest rates. Keynes also refuted the classical view that savings and investments were equal at the full employment level, arguing that since full employment is rare, savings-investment equality is found at less than full employment.

Keynes proposed two views regarding savings and investment equality:

• The Accounting or Definitional Equality: This states that savings and investments are necessarily equal in amount for the community as a whole, being different aspects of the same thing. In this sense, they are defined as the excess of current income over current consumption.
• The Functional Equality: In this view, savings and investments are equal only at the equilibrium level of income. Income is functionally related to savings and investments. When savings are more than investments, income falls, and when investments are more than savings, income rises. This dynamic process continues until savings and investments are not only equal but also in equilibrium.

While classical economics focuses on interest rates as the mechanism to balance savings and investments, Keynesian economics emphasizes the role of income changes and the distinction between different levels of employment.

The effect of investment on economic growth

The impact of investment on economic growth has been widely studied, with conflicting opinions on the matter. Some studies show that public investment, private investment, and foreign direct investment (FDI) have a positive impact on economic growth. However, other studies have found no relationship or even an inverse relationship between investment and economic growth.

According to classical economic theory, saving and investment are always equal in a fully employed economy, and both are functions of the interest rate. In this view, changes in the interest rate are the mechanism that brings about equality between saving and investment. When saving is less than investment, the interest rate rises, leading to a decline in investment and an increase in saving until they are equal again. Conversely, when saving is more than investment, the interest rate falls, causing investment to increase and saving to decrease until they are equal.

Keynes criticised the classical view, arguing that changes in income, rather than the interest rate, bring about equality between saving and investment. He also disagreed with the notion that the interest rate only shifts the investment curve, asserting that changes in the investment curve also lead to changes in the saving curve. Furthermore, Keynes refuted the idea that saving and investment are equal at the full employment level, stating that since full employment is rare, saving-investment equality is found at less than full employment.

In a study examining the impact of investment on economic growth in Vietnam, it was found that in the short term, labour and trade openness have a negative impact on economic growth. Meanwhile, in the long term, public investment has a negative effect, while domestic private investment, foreign direct investment, trade openness, and labour have positive effects.

Another study focusing on the United States concluded that not all forms of foreign investment are beneficial to host economies. While some sectors exhibit a positive correlation between foreign investment and economic growth, others show a negative effect. This difference is attributed to the distinct characteristics of developed and developing countries.

A study analysing the impact of investment on the economic growth of South Sumatra Province, Indonesia, found that investment, inflation, and road infrastructure development jointly have a positive and significant effect on economic growth. Specifically, investment and road infrastructure development were found to have a positive and significant impact, while inflation had a positive but insignificant effect.

In summary, the effect of investment on economic growth is a complex issue with varying findings across different studies and economic contexts. While some studies highlight the positive impact of investment on economic growth, others suggest a more nuanced relationship, with factors such as labour, trade openness, and inflation also playing significant roles.

The importance of financial intermediaries

Financial intermediaries are essential in the financial world, acting as middlemen between two parties in a financial transaction. They provide numerous benefits to individuals and entities, including safety, liquidity, and efficient markets. Here are several reasons why financial intermediaries are crucial:

Facilitating Financial Transactions

Financial intermediaries simplify the process of lending and borrowing money. They act as a bridge between individuals or entities with surplus capital and those requiring funds. By advancing short-term and long-term loans, financial intermediaries, such as banks, play a pivotal role in facilitating financial transactions.

Risk Management

Financial intermediaries enable individuals and entities to spread their risk. They achieve this by lending to multiple borrowers or investing in a diverse range of financial products. This diversification reduces the risk of loss through default. Additionally, financial intermediaries conduct thorough screenings to determine the creditworthiness and repayment ability of borrowers, further mitigating risk.

Cost Efficiency

Intermediaries create economies of scale by serving a large number of customers and offering specialised services. This enables them to reduce operating costs, which translates to more competitive rates for borrowers. Moreover, financial intermediaries often have access to large amounts of liquid cash, allowing them to cater to borrowers with strong credit ratings.

Access to Financial Services

Financial intermediaries provide individuals and businesses with access to a range of financial services. For example, commercial banks offer safe storage of cash and precious metals, while investment banks and mutual funds have investment specialists who help clients grow their investments across various asset classes.

Economic Growth

Financial intermediaries play a crucial role in promoting economic growth. They direct and channel savings towards investments and productive sectors of the economy. By efficiently allocating capital, they facilitate economic activities, business expansion, and the overall financial landscape.

In conclusion, financial intermediaries are vital for facilitating financial transactions, managing risk, providing cost-efficient services, offering access to a range of financial services, and promoting economic growth. They act as trusted advisors, connecting savers and investors, and ensuring the smooth functioning of the financial system.

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