Saturday, May 02, 2009

Keynes and loanable funds

Paul Krugman outlines the argument given by Keynes against the loanable funds theory and the view that increase government borrowing with force up interest rates by 'crowding out' the private sector.

What Keynes pointed out was that this picture is incomplete if you allow for the possibility that the economy is not at full employment. Why? Because saving and investment depend on the level of GDP. Suppose GDP rises; some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls:

Here is the diagram that Krugman uses.

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