ECONOMIC THEORY OF PARADOX OF THRIFT Case Study Solution
Paradox of Thrift
The paradox of thrift refers to the concept proposed by Keynes back in the time.It refers to the activity of the households and public sector, in times of economic downturns or prosperity. Cording to paradox of thrift, people tends to save more in good times, which depicts the healthy functioning of the economy, due to high disposable income people have in terms of savings.This savings leads to Fed to lower the interest rate, in order to motivate people to spend more and lose up the tied cost.The spendingthus improves the cycles of economy, and hence continues in the long run.
Also, saving money refers that the businesses and public have enough of cash to run the operations, thus outlining the activity of healthy activity. However, the term paradox is used, because it refers to two confidingstatement, yet confiscating with each other under same situation,which cannot be correct at the same time.
Here in the particular statement, Paradox refers two to statements. If the people are saving in the economy, the spending will decrease, which means that the economy will face the losses in the long run.Which is the reason fed reduces the interest rates, so to encourage the businesses and households to spend more,andthus to secure the functions of the economy. This is the particular reason forthe success of “sales” in businesses. However, the other statement refers that, if people andhousehold saves in the bank, the more the saving, the more the banks have pool of resources to invest in different activities in the economy, thus making the functions stable. Now the conflict arises, if people will not spend more, how the businesses will make profits, and if there are less savings how the banks will invest money on the economy.Dueto the particular deadlocks, the statement is named as “paradox”. (Hamm, 2014)
Money that is not consumed will be invested?
According to classical theory or Keynesian theory, “money that is not consumed (savings), will be invested in the economy. Now the question here is if the money is invested in the economy, how it becomes a problem?If people start saving money, the banks will have a lot of loanable funds to loan out in the economy that would increase the operations of the businesses, and thus will benefit the economy. However, there will be apoint when the bank will raise the interest rate, due to too many people or household seeking forthe bank loans. In such conditions if the bank raises the interest rate, it will increase the risk of default of borrowers in the economy, and thuswould lead to financial crisis or economic downturn. Insuch situation, the role of government emerges, to control the flow of money in the economy and the interest rates, to equalize the supply and demandof money in the economy. Thegovernment in such situationsagain lowers the interest rate which allows theborrowers to payback the loans, and thus saves banksand the economy from bankruptcy. Thecycle have direct effect on employmentrate, Sincethebusinessesreceive the loans at low rates the activity ofbusinessesincreases, due to cost saving, making the companiestohire more people, hence eliminating the unemployment. However, if theinterest rates increases, the loanpayment increases, which pressuresthebusiness to shut some of the additionalfunctions, leading to unemployment again. Here, the government itself analyzes the need to lower the interest rate, in order to secure the economic equilibrium, by encouraging borrowers to pay the debt in small amount. Thephenomenon, hence supports the classical Keynesian theory.
Krugman’s Normal line
Krugman proposed the theory that, whenever the trend of saving increases in the economy, the Fed cuts off the interestrates so to encourage the people to spend on low cost capitals, hence increasing the investment in the business, leading to healthy economy....................
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