Chapter 3. Equilibrium Interest Rate

The saving curve measures national saving. National saving is defined as output minus consumption minus government spending (Y – C – G). National saving is equal to private saving plus public saving. An increase in taxes will lead to a dollar for dollar increase in public saving. An increase in taxes will lead to a decrease in consumption and a decrease in private saving, meaning the change in taxes is equal to the change in consumption plus the change in private saving. Therefore the increase in public saving is greater than the decrease in private saving and national saving will rise.

If households spend a greater percentage of their income then they will be saving a smaller percentage of their income. This will reduce private saving, and hence national saving. The decline in national saving will shift the saving curve to the left, leading to a shortage of loanable funds. As a result the interest rate will rise.

If government spending declines, then public saving and hence national saving will rise. This will increase the quantity of loanable funds available to lend and the equilibrium interest rate will fall. When the interest rate falls, it is cheaper to borrow, and this will increase investment spending.

When the saving curve is a vertical line, the level of saving is fixed for any given level of the interest rate. This means that changes in the interest rate do not affect private saving or public saving. If private saving is not affected by the interest rate, then consumption is also not affected by the interest rate because disposable income is equal to consumption plus private saving.