Price level is the consequent of change in income

According to the saving-investment theory, price level is he consequent of the change in income than quantity of money.

At the equilibrium level of income, S = I or Y = C + I, the output and the price level in the economy tend to be stable. But saving and investment decisions are made by diverse groups of people and with different motives. Thus, there is every possibility of saving-investment disequilibrium taking place in the economy. Sometimes, investment may exceed saving and sometimes saving may exceed investment. This disequilibrium in saving and investment causes changes in output and prices.

i) Investment Exceeding Saving

Let us assume saving investment equilibrium and also assume that the investment expenditure increases in the economy without an equal reduction in the consumption expenditure. This is a case of an excess of investment over saving. This excess of investment over saving may be possible by an expansion of money through credit creation by commercial banks or by the dis-hoarding of wealth by the people. This excessive investment increases the money income of the consumers due to increase employment resulting from increased investment. The consumers in turn spend more on consumer goods. It raises the prices of the consumer goods and the profits of the producers manufacturing consumer goods. They tend to increase their investment in anticipation of still higher profits. This cumulative process of expanding investment continues.

During depression, as a result of the expansion of investment employment of idle resources and money income for the people will increase. There will be some increase in prices but it will not be a steep rise because of a simultaneous increase in output. Once full employment is reached, the prices will rise in proportion to the rise in money supply.

But the saving-investment disequilibrium will not last long. When income rises as result of investment exceeding saving, saving being a function of income also starts rising. This reduces the gap between investment and saving and once again saving-investment equality is attained. This new equilibrium is at higher levels of income, output, employment and prices.
Investment Exceeding Saving
In figure, original saving-investment equilibrium is at E where investment curve (II) intersects the saving curve (SS). The equilibrium level of income is OY. As a result of increase in investment, the investment curve shifts upward to IT which intersects the saving curved at the new equilibrium point E1. OY1 is the new and higher equilibrium level of income.

ii) Saving Exceeding Investment

The excess of saving over investment may arise in two ways:

i) As pointed by Keynes, saving function remaining unchanged, the excess of saving over investment is the result of a sudden fall in the marginal efficiency of capital unaccompanied by proportional fall in the rate of interest. This generally happens during the boom period of the trade cycle. The excessive saving results in a decline in the expenditure on consumer and investment goods. The demand and the prices of the consumer goods fall. The actual profits of the producers fall short of the expected profits. Consequently, they reduce the employment, output and income. But, when income falls, saving being a function of income, also falls. This reduces the gap between saving and investment and new saving investment equilibrium is reached at lower levels of output and prices.
Saving Exceeding Investment
In figure, original saving-investment equilibrium is at point E with an income of OY. Excess of saving over investment is depicted by a shift in investment curve form II and I’I’. The new equilibrium is at point E1 with a reduced income of OY1.

ii) Investment function remaining unchanged, the excess of saving over investment is the result of an upward shift of saving function. In this case too, the new equilibrium will be at a lower level of income and prices. In figure (B), the original saving-investment equilibrium is at point E with an income of OY. Excess of saving over investment is represented by a shift in saving curve from SS to S’S’. Then now equilibrium is established at point E1 with a reduced income of OY1. Thus, whenever saving exceeds investment, it initiates a process of cumulative decline in income prices and economic activity. It is in this sense that Keynes regarded saving as a private virtue but a public vice.

According to Keynes, saving function remains more or less stable in the short period. Hence, the business fluctuations in the economy are largely due to investment. An increase in investment leads to a rise in income, output, employment and prices and a decrease in investment causes a fall in the income, output, employment and prices.

In summary, saving investment theory of money, it is the inequality between saving and investment that causes price fluctuations (or the changes in the value of money) through changes in the level of income:
  1. If saving and investment are in equilibrium (S = I), the price level will tend to be stable.
  2. If investment exceeds saving, the price level will rise.
  3. If saving exceeds investment, the price level will fall. Thus, contrary to the quantity theory of money, the income theory of money emphasizes those fluctuations in the price level are due to the changes in income rather than in the quantity of money.

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