Question

1. Suppose the people in the United States increase their savings rate. How will this change affect the rate of economic growth in the United States?

Answer 1

Impact of increase in savings in Short Term:

In the short-term, a rapid rise in savings can cause a fall in consumer spending which can lead to a recession.

This rapid increase in savings and a fall in spending had a significant cause of the 2008/09 recession , since the  consumer spending accounts for high portion of the GDP,. The continued reluctance of consumers to spend results in economic stagnation or lower economic growth.

In this circumstance, a rapid rise in saving does not cause an equivalent rise in investment. Although banks see a rise in their deposits, they will be reluctant to lend to firms because the economic outlook becomes pessimistic. Also, in a recession, banks may not want to invest even if banks are willing to lend at low rates. A recession, usually results in a sharp fall of investments.

We tend to think of savings as good and virtuous; and at the right time, it is. But, if everyone saves at once, it can cause a drop in aggregate demand and cause a recession. Keynes called it the Paradox of Thrift.

Impact of increase in savings in Long Term:

On a positive note in the long run, we say the level of savings equals the level of investment( S= I) . Investment needs to be financed from saving. If people save more, it enables the banks to lend more to firms for investment.The Harrod-Domar model of economic growth suggests the level of savings is a key factor in determining economic growth rates. His model is as follows: Increased savings results in Increased investments , this leads to higher capital stock and thus higher economic growth.