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ECONOMIC THEORY OF PARADOX OF THRIFT Case Solution & Answer

ECONOMIC THEORY OF PARADOX OF THRIFT Case Solution

The concept of Krugman is somewhat similar to the Lawrence Kimball macroeconomic model of investment.Which states the importance of spending in the economy, leading to business success in the economy. The model propose, that even if the banks offers the loans to businesses and household to acquire the products or services, if they won’t spent on the services, how would the business cycle will run.

Higher savings can reduce the Investments?

Krugman proposed that if the saving level in the economy rises, the investment opportunities decrease with the same rate.He developed an inverse relationship between savings and investments. When people start saving, it depicted increased disposable income and a sustainable employment rate in the economy. Since,many people are employed and have disposable income, they tend to save which refrains the households to invest in any other activity or business.This leads to effect the business cycle, as the spending becomes lower than the earning,and hence effects the operations of the business.Which again effects the employment rate and creates an in equilibrium in the market, by laying off the workers to supports the operations in the market. Under such circumstances, the Fed lowers the interest rates, so to make the spending attractive to the households, which again stabilizes the cycle. Such concept is supported by LS-IS model(Investment-saving, Liquidity preference Money), in which if the money supply decrease in the market, the demand curve shifts downward, while the supply curves moves forward, hence creating a new equilibrium position on the curve. (Times, 2015)

2- classical and Keynes employment theory

The classical theory of employment focuses on the supply side or business side of the model. It proposes that with each increasing number of worker, the marginal profit will decrease, due to increased wage rate and inefficiency of the new hired worker. Also the theory focusses to reduce the cost of production, by lowering the wages rates which shifts the supply curve out ward. In the classical employment theory the wage cut represents the unproductive labor hours spent by the workers, hence decreasing the supply curve and effecting the demand curve also.Since, both demand and supply are interdependent, the change in the marginal activity at supply side, will directly affect the marginal activity of the demand side.Hence, effecting the overall employment productivity.

However, the Keynesian theory proposes the importance of effective productive labor, which decreases the need for more labor hours.In labor market, if one labor produces 2 units in a given time, it diminishes the requirement to hire an additional worker, thus reducing the cost of operations. It also makes the labor to earn more income, thus collectively makes the increase in the national income. The Keynesian model does not only focuses on the business side of the cycle, but also focus on the impact of raised income on the national income level, which again outlines the health and performance of the economy. Also the theory proposes that the classical theory only focuses on the supply side.However, if we dig deeper, the wage cut off on one side offer a great cost reduction to business operations, yet on other hand diminishes the spending level of the people on the goods produced by the businesses, due to low income level. Hence, the cycle of employment demand and supply does not affect the worker side, but it covers the businesses side also, and effects the business profitability adversely in long run.

In the given situation, the Keynesian theory is right, as it offers more derailed rationale about the increased productivity on the business activity. It depicts that the increased in number of productive hours by a productive worker will reduce the need for an additional worker, hence saves the cost for the company.However, these productive labor demands higher wages rates,which again offsets the benefits and tradeoffs from classical model of employment. Also, under such situation the price level also increases,due to increased wages rates, and hence increase the nominal cost. However, if the cost of the labor decreases,the businesses will hire more people to reach the equilibrium in the given situation. Also by hiring more people the marginal cost per each worker will also decrease, making the operations profitable. (Aziz, 2015)………………….

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