Saturday, January 17, 2009

Savings and Investment (3) - Producers

The second problem is that when interest rates were set artificially low by the central bank, producers took this as a signal to buy more capital goods. They have already purchased more capital goods than is required for a properly functioning economy. Just as households responded to low interest rates, by overspending on consumption goods, business responded by excessive spending on capital goods.

When demand for consumption goods declines and resources should be moving towards the production of capital goods, the demand for them also dries up, because businesses have already overspent on investment goods. Just when spare resources are freed up for the production of investment goods that would benefit the entire economy, businesses are trimming their investment plans to tidy up their balance sheets.

Fiddling with interest rates causes the relationship between consumption and production and saving investment get out of sync. The economy will go into recession, as demand for both consumption and capital goods declines at the same time.

This is the decline in aggregate demand that is dreaded by many modern economists. What they do not seem to understand is that the lack of demand is the consequence of the distortion caused by the actions of the central bank. Artificially low interest rates create excessive demand for consumption and capital goods that cannot be sustained. Something eventually has to give, and it hits both consumption and investment at the same time.

Modern economists advocate additional government spending to artificially stimulate demand, but this just perpetuates the dislocation of the economy.

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