Why does the supply of saving slope upward? Why does the investment demand slope downward? Identify the equilibrium in the market.
The supply of saving typically slopes upward because of the income effect and the substitution effect.
The income effect suggests that as income increases, individuals tend to save more. When people earn more, they have more disposable income, and they usually choose to save a portion of that additional income. Hence, an increase in income leads to an increase in saving, resulting in an upward-sloping supply of saving.
The substitution effect is another reason for the upward slope of saving supply. With higher interest rates, individuals are encouraged to save more because they can earn more returns on their savings. As a result, an increase in interest rates leads to an increase in saving, contributing to the upward slope of the supply curve.
On the other hand, the investment demand curve usually slopes downward due to the concept of diminishing marginal returns. As the level of investment increases, the returns on each additional unit of investment tend to diminish. Initially, as businesses invest more, they can expect high returns. However, as they continue to invest, the additional returns start to decline. This phenomenon leads to the downward slope of the investment demand curve.
The equilibrium in the market occurs at the intersection of the saving supply curve and the investment demand curve. At this point, the supply of saving matches the demand for investment. This equilibrium level of saving and investment ensures that there is no excess or shortfall in the market. Additionally, the equilibrium interest rate is determined at this point, at which saving and investment are in balance.