Tuesday, September 1, 2015

Savings vs Consumption

Consumption is neither good or bad. Ultimately, we will all consume.  However, it is when we consume that makes a difference. Also, in that choice, we delay some consumption things we acquire into the future, and that is called "Savings".  Savings is needed to "invest" into capital goods, education, technology, and the like, in order to make the future production grow.

This topic naturally opens up the door to the notion of the natural rate of interest. The natural rate of interest represents the time preference of consumption today, as compared to the consumption in the future. The Natural rate of interest is an important tool for entrepreneurs in the Capital Markets to accurately "price" out their services.

When interest rates are "price fixed" by the central banks, the same results happen as it does with other goods when Government mandated price fixing occurs: Shortages or surpluses take place in the marketplace(i.e recall the long gas lines in the 1970s )Individuals in the society can not valuate properly the prices, as it sends mixed signals on the allocation of those goods and services.

Prices act as messengers telling the individuals in the marketplace on how to allocate their individual preferences.  The result of this price fixing reveals in the drastic boom and bust economic cycles, as witnessed in 2008 in the Real Estate/Capital market.

In summary, Savings and consumption are both needed to grow an economy. Ultimately, it is production that drives the economy. Savings, if invested into those capital goods, can help make production more effective.

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