Wednesday, April 29, 2009

The Savings Paradox

Let's take a moment to review a theory proposed by John Maynard Keynes almost 100 years ago. Everyone would agree that it is beneficial for an individual to save money. However, what happens when a society saves too much? The savings paradox suggests that when society as a whole does not spend money less goods are consumed, leading to businesses being less profitable. Consequently, wages are lowered and jobs are lost, causing people to have less money and to be able to afford to save less. Thus, if an entire population saved more, our total savings rate would stay steady or even decrease over time because of lower incomes and a weaker economy.

Non-Keynesian economists argue that if people stop spending prices will fall, stimulating demand. Additionally, people have a choice of saving money either by putting it under their mattress or by loaning it to someone who will spend it. More people saving represents an increase in supply of loanable funds, which will lower the cost of borrowing. If the cost of borrowing is low, more people will borrow and spend funds, which will stimulate the economy and bring incomes back to normal levels.

This debate continues today. Whichever camp you fall into, almost everyone agrees that reasonable spending and saving levels are desirable. Besides, there is a difference between saving money and delaying purchases. Saving is a fiscally responsible action. Delaying purchases is the type of action that, done on a large scale, can cause an economy to falter.

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