Does a high interest rate increase savings?
...Thus, as long as we are talking about real interest rates being high, there would seem to be a dichotomy between the two statements in the question; investment cannot both rise and fall simultaneously. However, in the conditions mentioned above, there are some large factors ignored – namely the government and foreign trade. Firstly, however, we must question to what extent a higher interest rate really does act to increase savings. There is an argument that savings can go either way upon an interest rate rise – ‘an increase in the interest rate could either stimulate or depress saving.’ . The substitution effect for a saver, certainly, encourages more saving now that more can be had in the second period per amount set aside in the first; but the income effect means that the consumer, who is now richer, wants to spend more in both time periods. Thus we cannot with confidence say which way the saving rate will go upon an interest rate rise.This is backed up by Dornbusch, Fisher and Startz, who say that, empirically, the level of saving in an economy is relatively unaffected by the level of interest rates: ‘research suggests that the effects of interest rates on saving are small and hard to find.’ This does not provide a complete solution to the question above, however; there is little contention that interest rates do have a real effect upon investment, and thus savings would need to change negatively in order to counterbalance this. Saying that effects on saving are negligible is not good enough to extricate us from the problem. The formulation above of the equilibrium argument misses out, as I have said, the effects of government and foreign trade. With these added back in, the overall algebra becomes I = S + (TA –TR – G) – NX; investment equals savings plus net government budget surplus minus net exports. This presents us with a slightly different picture; when we take these two factors into account, we can see that the higher interest rates will still encourage foreigners to save in the domestic market. Thus this part of the equation will work in the same direction as the domestic savings. However, the government spending need not; and indeed one reason for higher interest rates in the first place is because the government has been running a large budget deficit, borrowing to sustain this, and so (TA – TX –G) may well be large enough, and negative enough, to allow us to reconcile the two statements – government spending making up the difference between the two. Monetary policy is, however, far from...