Explain the relationship between consumption and GDP. Why is consumption so important in the Circular Flow Model?
GDP refers to the total value of the final goods and services produced in a country over a specified period of time. On the other hand, consumption refers to the expenses incurred by the households on those final goods and services produced. Households incur expenses on such things as food, rent, health care, etc. which are the goods and services that are taken into account to make up the GDP. In the circular flow model, consumption is so important that, without it, firms will not invest since they will have nowhere to take the extra goods and services they invest for. This in turn means that the revenue generated by firms on sales of goods and services to pay up wages for their workers and rent for to owners will be absent.
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What has been happening to the US Savings rate over the last thirty years? How do you think the US-financed its investments before the economic crisis (2008) if the country was close to zero savings (see graph)? Was this situation (close to zero savings) good for the economy in any way? Explain
The US household savings rate according to the graph has been gradually declining and was closing into zero by the year 2007. On the other hand, household debt has been rising gradually and was about 135% by the year 2007 (Mui, 2010). What this means is that, just before the recent economic crisis, most of the US investments were being financed through borrowing as there were no enough savings to count on hence the high debt rate. Such a situation is definitely not good for the economy in the long run as it limits the capacity to invest.
However, the situation could mean something good to the economy in the short run if only people are opting to consume instead of saving in a demand induced recessionary economy. Such action by consumers would put to rest any further damage to the economy the cyclical recessionary effects caused by reduced aggregate demand. In turn, firms would generate more profits from increased sales and revert the cycle therefore creating employment and increase personal savings.
Why are Americans saving now? Why does the article seem to suggest that this is bad for the American economy? Do you agree? Explain
According to the article, Americans are saving now for future consumption (Ross, 2008). As is suggested in the article, such kind of saving is definitely not good for the economy. In the current situation, people are opting to save for future consumption and cut on current consumption in anticipation of tougher economic times ahead. With only slightly increased or same wage income for individuals and the stagnantly high unemployment levels, sacrificing current consumption for later consumption will only do further damage to the yet to recover and a weak economy. As people cut consumption in order to save, firms will eventually realize that they have nowhere to sell their products to leading to oversupply.
Aggregate supply will be more than aggregate demand prompting firms to devise strategies to cut on their production. In order for firms to remain profitable and competitive amid reduced production, they will have to cut their costs. To achieve this most firms will quickly go for the easily available option to cut on their labor costs by laying off unnecessary labor further exacerbating the already badly high unemployment levels. All these scenarios together will drown back the economy back into recession.
Mui, Y. Q. (2010). U.S. savings rate at highest level in a year, data show. The Washington Post. Web.
Ross, W. (2008) The affordable mortgage depression: Chart: US household debt vs. personal saving rates. Web.