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Sunday, January 26, 2014

Saving or Spending for Economic Growth?



Neoclassical growth theory states that higher saving rates can increase long-term wealth while Keynesian economics indicates that higher saving rates can lower consumption. Yun-Kwong Kwok in his paper creates a bridge between the two theories by studying the links of the Solow diagram (neoclassical) and IS-LM curves (Keynesian).  These two concepts are often covered separately in college because they do not easily mesh into a single framework.  People are left wondering if we should save or spend?

The first concept to understand is that the neoclassical model is a long-term model while the Keynesian model is more short-term.  One focuses on a longer-term trend while another focuses more on immediate needs. This is one reason why decision-makers who are looking for immediate results often use the Keynesian model. 

In the long-run Solow model, the total output Y of an economy is produced by capital K and labor L: Y=F(K,L).  Capital accumulates through net investment. Output is absorbed through consumption. Stability occurs when accumulation and consumption match. Standard of living improves to match total accumulation until the system is equal in inputs and outputs. 

An assumption of the Keynesian model is that when prices and wages are flexible the economy will be at full employment. Because prices are sticky, the economy deviates for a period from full employment. When demand for certain products produced by a country declines, so will the employment rate. In other words, you cannot keep producing if no one is buying and that means lay-offs and higher unemployment. 

The author found that an increase in the savings rate will first lead to short-run recession but will eventually create long-term growth. He argues that as the central bank increases the money supply it will decrease the interest rate and increase output. A recessed economy with cash infusion will move toward its long-run potential. If that potential is high then it can create benefits. However, an infusion of money that is working against a poor long-run potential will cause prices to increase and output, consumption, and investment to decline. Policy makers must understand the positive or negative long-term potential to determine if infusion, infrastructure improvements, or other policies will result in higher growth.

Comment: It would appear that a major miscalculation is the long-term productivity of the economy. When an economic system loses its fundamental competitive nature through not keeping up with worldwide competition an increase in debt/liquidity during a recession may improve the short-run situation but damage long-term growth through greater debt servicing expenses and lower productivity.  Yet it is a well-known tool that is easy to use and grab when situations become difficult. The question becomes what do we do with this debt once we get back to a normal economy that cannot afford to service it? Creating sustainable systems that continuously reinvest parts of their working capital and saves a percentage of their profits from lower transaction costs (improved profits) through infrastructure improvements allows for greater cash infusion with long-term liquidity and investment prospects. The problem we face is knowing which infrastructure improvements will raise business prospects, tax capital, and business investment. Since businesses work in an infrastructure platform improvement upon that platform raises their opportunities for success but needs to be done in a fiscally responsible manner. Doing so in a smaller hub allows for the proper experimentation for national policy development. 

Kwok, Y. (2007). To save or to consume: linking growth theory with the Keynesian Model. Journal of Economic Education.

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