Question

Explain what is wrong with the following statement: “Savings and investment spending may not be equal in the economy as a whole because when the interest rate rises, households will want to save more money than businesses will want to invest.”

Short answer

The statement is wrong because a stable economy requires investment spending to be equal to saving.

Step-by-step solution

Explanation

The statement lacks the equilibrium identity of investment and saving because the interest rate adjusts itself, and the economy achieves equilibrium again.

When the interest rate rises, it urges households to make more savings and businesses to borrow less. This increases the supply of loanable funds. With increasing supply and reducing demand, the interest rates fall.

Now the falling interest rate encourages more businesses to borrow and discourages savers. Thus, investment increases and saving decreases.

This increase and decrease in interest rate will last till saving matches investment, and the economy attains equilibrium.