Explain how, in the aggregate, increased savings could actually cause the economy to be worse off.?
Answer:
I was impressed with roger's economic text-book answer but it was rather technical and I thought might just add my layman intuitive understanding.
Like a household, the aggregate population of a country has to decide how much of its wealth it uses for consumption, and how much for saving/investment. It's an either/or case. The more you save, the less you have to consume. The more you consume, the less you have to save/invest.
It's not a case of one being better than the other.
The benefit of increased consumption is that it drives economic growth today. It also provides a domestic driver for growth which can be helpful in balancing reliance on exports.
The benefit of increased savings/investment is that, by delaying consumption today and investing the money instead, you are setting the scene for greater growth in the future. Greater investment, everything being equal, would lead to a higher future potential growth.
Now, if you have an economy with too much consumption and not enough savings (United States being the key example), this is not good. But too much savings is not good either, especially when there are not good investment opportunities around. Many asian countries suffer from this problem. They treat current account surplus and trade surpluses as if it were inherently beneficial to the economy. This outdated mercantilistic view of trade and economy is not helpful. Too much savings means weak consumption, meaning your economy is too much dependent on consumption by other countries. Also, consumption, in a broad sense = standard of living. If you neglect your own domestic market, you are basically supressing the standard of living of your own people to subsidise the lifestyles of other countries' consumers.
If a rich man hordes his money then that is money not going to workers or new business ventures. For instance, part of Mars company was started with 20% capital from Hersheys. If Hersheys decided to horde that money we would never have had m and ms and mars bars.
There really is a limited money supply. If you make more money in the marketplace then it's coming out of someone else's pocket. Likewise if you keep it, it's not going back into another person's pocket.
In a closed economy.
Y=C+I+G
If people dun consume, they can save money.
Savings won't actually cause the economy to be worse off because S=I As savings go up, the supply of loanable funds for investments goes up too and interest rates go down, prompting businesses to take loans. The economy is unaffected.
If C goes down, I will go up, in the end, equilibrium is achieved.
This can be explained from the "paradox of thrift". In fact, the paradox of thrift is an example of the wider concept of "fallacy of composition", meaning what is true for the individual or part is not necessarily true for the group or whole.
The objective of saving from an individual's point of view is to prepare for the rainy days and is, therefore, a virtuous personal trait. From an economic point of view, saving releases resources from the production of consumer goods to the production of investment goods, thereby enhancing the future productive ability of the economy thereby possibly leading to an increase in future income, which benefits everyone.
However, what if all, if not most, households attempt to increase their savings (thereby leading to an increase in autonomous savings at every level of income)? The saving schedule will shift up while the investment schedule remains unchanged, leading to a reduction in the equilibrium real GDP (as pictured by the leakages-injections approach to national income).
Of course, it is also possible that instead of autonomous saving increasing (parallel shift in the saving shedule), it is the marginal propensity to save, MPS, that increases. This means that households, in the aggregate, increase the amount of every last dollar of income that is saved. If this is the case, the saving schedule pivots upwards about the vertical intercept (at which Y = 0), i.e. becomes steeper. Again, with the investment schedule unchanged, equilibrium real GDP also decreases.
<Some extra bit to ponder upon. Think again, which is more likely? This might be a subject of econometric drilling. Both are equally likely. I would say an increase in MPS might be intuitively appealing. Those who earn higher income probably has more dollars to save (S = So + MPS*Y) than those earning a meagre income, and so an increase in MPS leading to a greater increase in S at higher Y than at lower Y is intuitively appealing. Yet others might argue that high income earners might be more extravagant in their lifestyle than the low income earners and so the latter might have higher MPS than the former. This would suggest different MPS's for different income groups and so a standard economy-wide MPS is counter-intuitive, let alone an economy-wide increase in MPS. Yet, on the other hand, an increase in autonomous saving (So) is not unlikely if everyone has the same expectations, e.g. regarding future income and prices etc.>
When viewed from the aggregate output-expenditures approach (or simply the Keynesian cross diagram or the 45 degree line diagram), for the first case of an increase in So, the consumption schedule and hence aggregate expenditure (AE) curve will shift downward because an increase in So means a decrease in autonomous consumption, Co. This leads to a multiplied decrease in equilibrium real GDP.
From the second perspective of an increase in MPS, we should notice that marginal propensity to consume MPC actually decreases (since MPS + MPC = 1). When this happens, the consumption schedule pivots downward about the vertical intercept (at which Y = 0), i.e. becomes flatter. Accordingly the AE schedule becomes flatter, leading to a multiplied decrease in equilibrium real GDP.
Viewed from both approaches (the leakages-injections approach or the Keynesian Cross diagram) and under different assumptions (increase in So versus increase in MPS), increasing aggregate saving not only has not increased your future purchasing power but the resulting decrease in equilibrium real GDP will probably reduce it. This is how, in the aggregate, increased savings could actually hurt an economy (fall in real GDP), and the individuals (reduction of personal disposable income and purchasing power).
The answers post by the user, for information only, FunQA.com does not guarantee the right.
More Questions and Answers: