Friday, January 16, 2009

Savings and Investment (2) - Consumers

Artificially low interest rate interest rates cause dislocation in the economy. Households respond by reducing saving and increasing consumption (for most households, a car and a home are consumption goods and not investment goods).

Big spending on consumption goods makes people feel good, but it cannot last forever. When interest rates go up again, personal debt becomes a burden and interest payments take an ever greater share of disposable incomes. Households are forced to reduce spending on consumption goods to get their balance sheets back in shape.

When the demand for consumption goods declines, businesses have to cut back on the production of consumer goods. Ideally, the resources that are no longer needed to produce consumer goods should be switched to the production of investment goods. If this does not happen, the economy will decline as the resources that previously produced consumers will be underemployed.

Unfortunately, two things have happened that make this shift in resources impossible. Firstly, there is no additional savings available to fund any new investment expenditure. Although households have reduced their expenditure on consumption, their surplus income does not go into savings. Most of it goes toward payment of interest. Any surplus not used on interest is not available to fund additional investment, because it must go towards repayment of debt. Although there has been a decline in consumption, there are not additional savings to fund the purchase of new investment goods.

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