Question

Suppose that as a result of the recent economic turmoil in financial markets, the expectations of an upcoming recession have risen. As a result, people become more thrifty and save more and consume less.

A) For a given interest rate and a fixed price level, what happens to employment and output when this happens? What happens to private savings?

B) Redo the above analysis when the interest rate is allowed to adjust. Now what happens to private savings? Is there a paradox of thrift (savings)?

C) In general, can there be a paradox of thrift in the market clearing model – where the price level is allowed to adjust? Explain.

*I had to post this question again as someone answered it with a completely unrelated answer, probably in hope of getting their 'answers' number up or something. Any answer related will be greatly appreciated, thanks.

Answer 1

a) keeping interest rate and price level constant if people start to save more then definitly they will consume less which means there will be lack of effective demand in the market. if there will be less demand then according to keynesian economics output and employment both will decline. according to keynes in a nation effective demand determines output and level of employment, so there will be less output and employment as a result of lack of effective demand.

b) if interest rate is allowed to adjust then due to increase in savings rate the money supply will decline in the economy and as we know supply of money and rate rate of interest are inversly related the rate of interest will increase and make people save more to take advantage of increased rate of interest. there will definitly arise a paradox of thrift here because as people will save more in the present and consume less, output and employment will decline and income in the next period will also decline which will cause the paradox of thrift.

c) if the price level is allowed to adjust then if demand decreases price level will also decline and will help to clear the market so there is very less chance of paradox of thrift to take place. but if consumer are really pesimistic in there economic behavior then there is a chance of pardox of thrift to happen.