Question

Why is there a trade-off between the amount of consumption that people can enjoy today and the amount of consumption that they can enjoy in the future? Why can’t people enjoy more of both? How does saving relate to investment and thus to economic growth? What role do banks and other financial institutions play in aiding the economic growth process?

Short answer

Consuming less today and saving the rest of the income will help in increasing future consumption. In this way, society trades off between current and future consumption.

A part of current consumption is a trade-off with future consumption. If the society chooses to enjoy the whole of current consumption, there will be no increase in future consumption.

Savings are required to fund the economic investments in the economy. These economic investments increase the production capacity of the economy, which in turn leads to economic growth.

Banks and financial institutions borrow the savings from the households and lend them to the investors. These investors use the savings for economic investments in the economy, which aid the economic growth process.

Step-by-step solution

Trade-off between current consumption and future consumption

Savings occur when there is a difference between the current income and consumption by the households. These savings are directed to fund the economic investments, which increase the productive capacity of the economy in the future through research & developments and more efficient capital goods.

The increased production capacity increases the output per person, which will increase the future consumption of the households. Thus, a part of current consumption is forgone in the form of savings to finance the growth in the future through economic investments. In this way, society trades off between present and future consumption.

Reason why it is not possible to enjoy more of current and future consumption

Economic investments require funds for the research and development of more efficient capital. If society consumes all of the current income, there will be no funds available for economic investments. Thus, the economy will not increase its productivity level in the future.

Since the savings made by households from current income are utilized for economic investments, it is impossible for society to experience the whole of current and future consumption.

Role of banks and financial institutions

Banks and financial institutions help direct the savings from the households to the investors to utilize for economic investment. Households deposit their savings to the banks and financial institutions upon which they earn interest.

The banks lend the savings to the businesses and investors on higher interest rates. Investors use this money for the development of advanced technologies and the production of more efficient capital goods. In this way, banks and other financial institutions contribute to economic growth.