Paradox of Thrift :Keynes’

In the great depression of the 1930s, GDP fell, unemployment rose and the UK experienced a long period of deflation. In response to this disastrous economic situation, mainstream economists were at a loss as how to respond. Such a lengthy period of disequilibrium didn’t sit well with Classical theory which expected markets to operate smoothly and efficiently.




One policy the National government did approve was the cutting of unemployment benefits. The rationale was that in times of a depression the govt should set an example by reducing its debt. This example actually inspired members of the public to send in their savings in the hope that it would help the economy.



Alas this is precisely the worst response the Government could have taken. By reducing benefits they further reduced consumer spending and AD. This made areas of high unemployment even more impoverished. When people saved rather than spent their money it just made the recession worse. It was J.M. Keynes who was one of the most enthusiastic proponents of increasing government spending, even if it meant increasing the levels of borrowing. If the govt borrowed they could kick start the economy and hopefully generate a multiplier effect which would enable the economy to start growing.



In the UK and US Keynes was largely ignored until after the war and as a consequence the UK economy experienced high levels of unemployment for the remainder of the decade.



This phenomenon explains why Keynes talked about the “paradox of thrift”. Saving money reduces spending, output and therefore increases the level of unemployment in an economy.

Success of Monetary Policy

The aim of monetary policy is to achieve the governments inflation target of CPI= 2% +/-1. They will also consider impact on economic growth and unemployment. But control of inflation is their primary objective.




Factors which determine success of Monetary Policy



1.Accuracy of inflation forecasts.
Monetary policy is pre emptive which means they try to reduce inflationary pressures before they occur. If inflation is higher than predicted, then interest rates will be too low to control inflation. Inflation predictions could be wrong if there is an unexpected rise in cost push inflation, for example an increase in the price of oil. In the past 15 years the MPC have benefited from generally low global inflation, However some economists feel that this “golden era” of price stability may not continue indefinitely. E.g. economic shocks associated with rising commodity prices.

2.Time lags.
 It is estimated interest rate changes can take upto 18 months to have their full effects. For example if interest rates rise then people who are currently spending on investment will not stop straight away. They will continue with their project. However higher interest rates may deter future projects from starting. By the time interest rates have had their desired effect it may be too late to reduce inflation. (This is why the MPC is always trying to predict future inflation trends)

3.Interest Elasticity of Demand.
This measures how responsive demand is to a change in interest rates. For example if consumer confidence is very high then higher interest rates may not deter consumer spending. This is because people expect to make more money in the future so are willing to borrow at higher levels of interest.

4.Effects of interest rates not equally shared.
 The effect of rising interest rates effects some much more than others. For example in the UK many have high levels of debt through mortgages. Thus first time buyers with large mortgages will be effected by interest rate changes much more than older people who have paid off most of their mortgages. To reduce inflation may cause financial hardship for a small % of the population who have very high levels of mortgage debt.



5.Other Variables
 Interest rates effect other variables in the economy. Higher interest rates increase the value of the £ (through hot money flows). This causes problems for exporters and may worsen current account. Higher interest rates also have a disproportionate effect on the volatile UK housing market.



6.Inflation expectations.
 The success of monetary policy depends upon credibility of the Monetary authorities. If people have low inflation expectations then it is much easier to keep inflation low. Since independence the MPC have benefited from a reduction in inflation expectations. This is partly due to the credence people give to an independent body rather than politicians with a poor track record of keeping inflation low.



7.Levels of Government debt.
High levels of government debt generally put upward pressure on interest rates. This is because to attract enough people to buy government bonds interest rates on these securities need to rise. This puts upward pressure on interest rates throughout the economy.





Note in Japan Monetary policy became ineffective because they experience deflation. Because interest rates cannot fall below 0% this meant the Japanese real interest rates were too high for the state of the economy. Monetary policy could not be used to reflate the economy. However deflation is unlikely to be a real problem in UK for the foreseeable future.

Balance Of Payments (Economics)

Balance Of Payments


The Balance of Payments is a record of a country’s transactions with the rest of the world. It shows the receipts from trade. It consists of the current and financial account



Current account

This is a record of all payments for trade in goods and services plus income flow it is divided into 4 parts



•Balance of trade in goods (visibles)

•Balance of trade in services (invisibles) e.g. tourism, insurance

•Net income flows (wages and investment income)

•Net current transfers (e.g. govt aid)





2.Financial account

This is a record of all transactions for financial investment. It includes



•Net investment from abroad (e.g. A UK firm buying a factory in Japan would be a debit item)

•Net financial flows - These are mainly short term monetary flows such as “hot money flows” to take advantage of exchange rate changes

•Reserves

(note the Financial Account used to be called the Capital Account)







3.Capital Account

This refers to the transfer of funds associated with buying fixed assets such as land



•Balancing Item

In practice when the statistics are compiled there are likely to be errors therefore the balancing item allows for these statistical discrepancies



Balance of Payments Equilibrium

•In a floating exchange rate the supply of currency will always equal the demand for currency, and the balance of payments is 0.

•Therefore if there is a deficit on the current account there will be a surplus on the financial account.

•If there was an increase in interest rates this would cause hot money flows to enter into the UK, therefore there would be a surplus on the financial account

The appreciation in the exchange rate would make exports less competitive and imports more competitive therefore with less X and more M there would be a deficit on the current account