As described on the previous page, Keynesian macro theory proposes that a drop in spending can lead to involuntary unemployment and wasted resources. But classical critics argue that this idea is incorrect because it ignores the effect of market adjustment mechanisms that assure enough aggregate demand to purchase the economy’s potential output.
This page describes how the classical theory proposes that interest rate adjustment could do the job of keeping demand at the potential output level. We then present the Keynesian counterargument that leads to an important, but controversial, result: the paradox of thrift.
Do Falling Interest Rates Automatically Offset a Drop in Demand?
Assume that we begin in an economy that operates at full employment and potential output. In the aggregate, households, firms, and governments spend enough to purchase all that is produced.
For readers who like supply and demand curves, the interest rate adjustment process and the way it automatically closes a possible demand gap is presented here using a simple graph.
Now, the economy receives a negative “demand shock” when an individual decides to forego $100 in consumption in an effort to raise her saving. This lowers aggregate demand by $100, potentially opening a gap between production and sales for some firm. But the classical argument asserts that the newly saved money does not simply disappear. Where does it go?
Let’s exclude the possibility that people stuff their new saving into the mattress. Instead, the $100 in new saving is deposited into a savings account, giving a bank extra money to lend out—that is, the bank has more “loanable funds.” The bank does not simply want to sit on the newly deposited funds (that would be the equivalent of the saver stuffing the money into her mattress). To attract new borrowers, the bank lowers the interest rate that it charges on loans.
Say’s Law says that “supply creates its own demand.” In certain types of economies, this result certainly holds. Consider an isolated tribal economy that produces only corn. The tribe may decide to consume fewer ears of corn in the winter to have seeds for spring planting. The saved portion of the crop, that is, the corn not eaten after the harvest and put in the granary for next season’s planting, is an investment in future production. In this case, an act of saving (not eating some of the corn) is at the same time an act of investment (storing the corn for next year’s seed). There is always demand for the corn that is produced: either it will be consumed or invested.
In our modern economy, instead of saving seeds, we deposit money into a savings account; and instead of grain warehouses, we have banks that channel the “seeds” the household sector saves into business investment. The paradox of thrift section shows, however, that the simple intuition from a corn economy need not apply to a modern monetary system.
This decline in the market interest rate is the key to filling the demand gap created by higher saving. The lower interest rate makes loans cheaper and encourages firms to borrow more. Firms spend the newly borrowed funds on new equipment, facilities, or technologies; that is, business investment rises. Moreover, a lower interest rate reduces the reward for saving and therefore encourages other individuals to save less and spend more. Both the rise of investment and the rise of consumption induced by the lower interest rate increase demand, offsetting the reduction in demand created by the rise in saving at the initial interest rate.
The interest rate keeps falling until the supply and demand for loans again balances. This equilibrium will happen when the rise of investment plus the decrease of saving eliminates the new supply of funds that our frugal individual deposited in the bank to start out the market adjustment process. Of course, demand has shifted from consumer goods to investment goods, which will surely require some change in the allocation of production. But the interest rate adjustment mechanism assures that there is no overall shortage of demand, spending just shifts from one part of the economy to another.
This result helps to explain one version of what is often called Say’s Law: supply creates its own demand. In other words, there will always be enough spending to purchase the economy’s potential output. Say’s Law requires that there be economic mechanisms to assure that some household or firm will purchase whatever the economy is capable of producing when it fully uses its resources. In the case analyzed here, the interest rate does the job. While the discussion above starts with a decline in consumption, the same mechanism could work for other sources of low demand such as a reduction in business investment or a decline in government spending. In every case, lower demand causes an excess supply of funds in the banking system that induces a decline in the interest rate which encourages more spending until demand is restored to a level sufficient to purchase potential output.
This mechanism corresponds intuitively to our experience as we run our own household budgets: if we cut consumption the money we save does not disappear, it ends up in the bank, and the bank must do something with it. This kind of intuition makes the description of the loanable funds interest rate adjustment described above, in the minds of many economists and commentators, seem like an effective criticism of the basic logic of Keynesian demand-side macroeconomics. But a deeper look shows that this simple story has a fundamental flaw. When we address this problem the story changes in a way that supports the Keynesian position.
The Paradox of Thrift: Keynesian Response to Say’s Law
The classical mechanism for restoring demand to purchase potential output is based upon an essential, but incorrect, implicit assumption. The analysis assumes that total income for all agents in the economy remains constant when saving increases. The theory falls prey to the “fallacy of composition” trap. That is, what seems intuitive for an individual may not hold for the entire economy.
When an individual saves more money, that person will necessarily reduce their spending by that same amount. Since one person’s spending becomes another person’s income, decreased spending destroys income. Ignoring this crucial fact leads to the fallacy of composition.
To understand the link between spending and income in more detail, consider a person who decides to save a higher percentage of his income. Suppose that he had been buying a fancy café latte each weekday from the local barista, but to save $100 more each month, he decides to cut out buying coffee altogether. As a result of our saver’s decision to save more now, the owner of the coffee shop will see her income decrease by $100 each month. Since the owner’s total income has decreased, she must either spend less or save less (or, more realistically, some combination of the two). For the sake of simplicity, suppose the owner keeps her spending constant, and therefore opts to reduce her saving by the full $100 that her income fell. In this case the coffee shop owner’s reduced saving completely offsets the greater frugality of her former customer. Even though one person initially decides to save more, the effect of this decision on someone else’s income prevents aggregate saving from increasing.
Now consider the more realistic case in which the coffee shop owner opts to reduce her spending by at least part of the $100 decline in her income. Then, the initial offset to her customer’s higher saving is just partial. But her lower spending starts the adjustment process again as she will destroy some income for some other business where she spend less, passing the problem along to another part of the economy. The next person hit by lower income will likely reduce his saving some and pass along lower spending to yet another business. Indeed, simple modeling shows that income will continue to be destroyed as spending cuts ripple through the economy until some combination of agents have cut their saving by a total of $100, again fully offsetting the $100 saving increase by our more frugal coffee drinker.
The income destruction caused when some individuals save more prevents any increase in total saving. This outcome may seem paradoxical, but it is a logical result of recognizing that one person’s spending creates another person’s income. And this result shows why the classical interest rate adjustment mechanism described above does not work. Since an increase in desired saving by some people does not increase the total saving in the economy, the supply of loanable funds never increases. Thus, the first step in the classical mechanism to restore demand fails; there is no downward pressure on interest rates in the loanable funds market and therefore no reason for others to increase their investment or consumption.
This result is the paradox of thrift. Individual attempts to save may increase that particular individual’s saving, but total saving in the economy does not increase.
Earlier on this page, we described the classical demand adjustment mechanism roughly by saying that when people save more, money does not disappear. Rather, the classical approach proposes that the money flows into the loanable funds market, lowers interest rates, and stimulates demand. But we now see that, in a sense, the “money,” or more accurately someone’s income, does disappear when there is a new act of saving in the economy.
The result is that there is no interest rate adjustment mechanism to restore demand when people decide to spend less. So, a fall in aggregate spending reduces the amount firms sell and lowers their sales expectations. Firms will then cut employment and some of their resources will sit idle. The newly unemployed workers and business owners who now have lower profits will reduce their spending, causing demand to fall further, firms to produce even less, and so on (this is the multiplier). It is easy to imagine this phenomenon taking on a snowball effect, resulting in lower aggregate saving, a decrease in spending, lower aggregate income—and, possibly, a recession.
Understanding the paradox of thrift reveals that the classical interest-rate adjustment mechanism fails to solve the insufficient demand problem. Demand can indeed be a constraint on production and employment.
Critics of Keynesian macroeconomics argue that falling interest rates prevent an overall shortage of demand in the economy. This loanable funds theory seems to imply that any reduction to demand from higher saving will be channeled into investment, an alternative source of demand.
- This criticism does not recognize that an increase in one person’s saving must destroy another’s income, an accounting reality that explains why interest rates do not adjust to assure that there will be enough demand to purchase potential output.
Keynesian economics, in our MWM perspective, stands up well to the criticism that interest rate adjustment assures there will be enough demand to get us to full employment. To consider the logic and evidence behind another economic mechanism often assumed to fix the problem of insufficient demand please proceed to Will Wage and Price Adjustment Cure Unemployment?.