How the Economy Really Works

William Foster and Waddill Catchings committed this same error. As Hayek pointed out in his critique of the Foster-Catchings debate, investment is actually multistaged and changes form and structure when interest rates rise or fall. Investment is not simply a function of current demand, but of future demand; both long-term and short-term interest rates influence investment and capital formation (Hayek 1939 [1929]). For example, suppose the public decides to save more of their income for a better future. Spending for cars, clothing, entertainment, and other forms of current consumption might level off or even fall. But this temporary slowdown in consumption does not cause a broad-based recession. Instead, the increased savings leads to lower interest rates, which encourage businesses, especially in capital-goods industries and research and development, to expand operations. Lower interest rates mean lower costs. Businesses can now afford to upgrade computers and office equipment, construct new plants and buildings, and expand inventories. Lower interest rates can even reverse the slowdown in car sales by offering cheaper financing to prospective car buyers. Contrary to the dire predictions of the Keynesians, an increase in the propensity to save pays for itself. It does not lead to a "recession and poverty for all" (Baumol and Blinder 1988, 192). Only the structure of production and consumption changes, not the total amount of economic activity.

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