Home > Harrod-Domar Model, Macro > Saving, consumption and growth

## Saving, consumption and growth

In simplest terms, economic growth is the result of deferring consumption now, so that you can get more production later.

An economy produces a variety of goods, the act of production generates income. That income is used to buy goods. We can roughly divide these into two types: consumption goods and capital goods.

Consumption goods are just things that are produced for the purpose of satisfying human desires in the here and now. Capital goods are things that are produced for the purpose of producing other things. The mechanism by which income ends up being spent on capital goods, is through saving. When households get their income, they will spend a portion of it on consumption goods and they save the rest of it. This saving becomes ‘loanable funds’ which firms use to borrow for investment. If you think about it, saving is really just the opposite of borrowing, when somebody takes out a loan, they can only do that because somebody else is saving. The reason you get paid interest on your savings in a savings account, is because when you put your savings in a bank, the bank is lending them out to other people and charging them interest.

So the higher the proportion of household income that is used for current consumption, the less is being saved, and when there is not as much being saved, there are not as many funds available for firms to borrow to invest in capital goods. So what you want is a higher ‘saving rate’ in the economy, because if people can hold back a bit on current consumption, and save a bit more, then firms have more loanable funds available with which to invest in capital goods. These capital goods are what is going to drive increased levels of production in the future. In models like the Harrod-Domar and Solow model, economic growth comes from accumulating more capital goods, often described as increasing the capital stock.

Households spend income on consumption goods and save the rest, so of the overall income in the economy you get an equation $Y_t = C_t + S_t$, or national income in year t is equal to the amount of consumption in year t plus the amount of savings in year t. The savings make available a pool of loanable funds that firms use to buy capital goods (investment).

From this you get the first idea which is used in growth models: the idea that the amount of saving in the economy determines the amount of investment. The more saving is going on, the more loanable funds are available to allow firms to invest. It’s not an exact one for one relationship but it is a useful assumption on which the simple forms of growth models are based: if you assume that savings are equal to investment then you get $S_t = I_t$ so $Y_t = C_t + I_t$.

Remember that the total amount of saving is a proportion of national income, so we can use the concept of a saving rate. If say national income is 1000 and the saving rate is 20% or 0.2, then total saving is 200. If we define small letter s as the saving rate then $S = sY$. This means that $I_t = sY_t$.