In classical model, saving and investment are functions of
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The classicists believe in the existence of a fully employed economy where saving and investment are always equal. According to them, saving and investment are a function of the rate of interest. Algebraically, S =f(R) and l = f(R) where R is the rate of interest.
Therefore, S = I. In a period of less than full employment, the inequality between the two is obvious which can be brought to equality through the mechanism of interest rate. When the rate of interest rises, saving rises and investment declines.
On the other hand, with a fall in the rate of interest, saving falls and investment increases. If at any time, saving is less than investment, a rise in the rate of interest brings a decline in investment and increase in saving till saving equals investment.
On the contrary, when saving is more than investment, the rate of interest falls, investment increases and saving declines till the two are equal at the new interest rate. This is explained in Figure 1, where saving and investment are measured on the horizontal axis and the rate of interest on the vertical axis. SS1 is the saving curve which moves upward to the right with the rise in the interest rate, II is the investment curve. Both intersect at E when the rate of interest is OR.
The economy is in full employment equilibrium because both saving and
investment equal RE. Suppose investment increases (shown by I1I1 curve) to RH, but saving is RE which is less than RH investment. The equality between the two can be brought about by raising the rate of interest to OR, where the SS1, curve intersects the I1I1 curve at E1. On the contrary, if investment falls from RE to RK (shown by I2I2 curve), saving RE>RK and a fall in the rate of interest to OR2 brings the equality between saving and investment at E2.