Thursday, January 15, 2009

Savings and Investment (1)

An interesting aspect of a free market economy is the way that savings are matched with investment. Decisions about saving and investment in capital processes are often made by different actors. Investment decisions are made by entrepreneurs and households. Savings decisions are made often made by people and households.

The link between these independent actors is the interest rate. When interest rates rise, people will save more. When interest rates fall, more potential projects become economic, so businesses and entrepreneurs invest more. In a free market, interest rates rise and fall to clear the market and ensure that savings are matched by equivalent investments.

Banks often act as intermediaries between savers and producers. Savers deposit their spare wealth with the bank and receive interest. Producers borrow from the bank to purchase capital goods to increase the productive capacity of their business. Their increased productivity improves living standards for everyone.

This all goes wrong when governments give their central banks authority to set interest rates. A central banker does not know the future, so he do not have enough information to set the interest rate. Following the dotcom crash in 2000, central banks pushed interest rates down, leading to the housing boom and following credit crunch.

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