What is Capital Saturation

Capital saturation occurs in an economy when real income is high and is expected to continue to rise, which in turn causes the general public, corporations and even public entities to concentrate on consumption rather than on saving. This combination can lead to a stronger economy, but it could eventually lead to an economic bubble.

BREAKING DOWN Capital Saturation

Capital saturation is driven in part by a sizable level of real income, which refers to one’s income after taking into consideration the effects of inflation on purchasing power. For example, if you receive a 4 percent salary increase over the previous year and inflation for the year is 2 percent, then your real income increases by 2 percent. A backdrop of low inflation can accelerate capital saturation, because it leaves more spending money in the hands of consumers and businesses alike.

More frequently, though, capital saturation is associated with a low interest rate environment. Low rates tend to encourage spending and discourage saving. Instead of earning low yields on savings accounts or fixed-income investments, for example, many consumers will choose to splurge on higher ticket items, while companies increase their capital expenditures and seek to create more jobs.

While this may sound like an ideal backdrop in which to live and work, capital saturation can ultimately result in a large-scale problem. Given its influence, capital saturation could spark an economic boom that eventually reaches a state of euphoria, causing the economy to become fully dependent on the current conditions of prosperity. If the elevated levels of consumption are reduced too harshly or too swiftly, perhaps due to an economic shock or increase in interest rates, a large number of businesses will be left with excess capacity in their facilities. At the same time, consumers could find themselves overextended on credit. A shift away from this bubble-type of economy may eventually result in a bust, like such historic example as the Great Depression in the 1930s or the Great Recession of 2008–2009.

The Acceleration Principle of Capital Consumption

The acceleration principle is an economic concept that draws a connection between the rate of change of consumption and capital investment. According to the acceleration principle, if demand for consumer goods increases, then the percentage change in the demand for machines and other investment necessary to make these goods will increase even more. In other words, if income and therefore consumption increases, there will be a corresponding but magnified change in investment. It is important to note that this principle does not compute the rate of change in capital investment as a product of the overall level of consumption, but as a product of the rate of change in the level of consumption.