A lower real interest rate makes saving less attractive while more projects become feasible, which produces a higher investment demand for money.
If the supply of savings increases from S1 to S2 (a lower line means more supply at a given price) then the interest rate will drop from R1 to R2 while the quantity of investments and savings will increase from IS1 to IS2. If investment demand then drops from I1 to I2, then the interest rate will drop further from R2 to R3 while the quantity of investments and savings will decrease from IS2 to IS3.
There are some issues with the assumptions of classical economics. Businesses may continue production as long as the price exceeds the variable costs of making the product so overproduction may persist for a longer period of time. If prices drop, people may not start to spend more. They may wait until prices drop further. Because employment and incomes are dropping, people may become more cautious. This can cause a deflationary spiral.
If labour drops in price, its supply may increase rather than decrease because people may try to make up for the income lost. This could create a race to the bottom in wages. To deal with this issue, labour unions have tried to corner the market for labour and governments have introduced minimum wages. Because there are labour unions and minimum wage laws, the market for labour is not efficient, making it difficult to adjust prices downward when there is lack of demand for labour.
Most people save for a specific purpose, for example retirement. Those savings depend little on interest rates. Savings may even reduce when real interest rates are high as the perceived objectives can be achieved with less effort. Lower real interest rates may therefore increase savings. If people are cautious because they are unsure about their future, they may start to save more regardless of interest rates.
Banks can create money and not all loans are made out of savings so investments (I) do not equal savings (S) and the market interest rate is not the natural interest rate. The market interest is lower than the natural interest rate when the economy is booming. As a consequence bad investments are made during the economic boom.
rates cannot go negative even when the market equilibrium for savings
and investments is at a negative interest rate. People prefer to keep
savings in cash below a certain rate of interest. During an economic
crisis savers may demand higher interest rates to compensate for the
risk of default while lower interest rates may be needed to sustain
the economy and reduce the risk of default.
Economic cycles, recessions and depressions
Keynesians see low demand combined with excess savings as the primary cause of economic depressions, often called general glut. The circular flow of money (figure 4) is an important element in Keynesianism as is the equation National Income (Y) = Consumption (C) + Investment (I). If consumption (C) reduces then investment (I) must rise. If demand is lower than anticipated, excess investments are made in unsold inventory. As a consequence production will be lowered as will subsequent investments. This may cause a downward spiral that ends at a lower equilibrium national income with a considerable level of unemployment.
figure 4: circular flow model by Natural Money
figure 4: circular flow model
following example may illustrate this. Suppose that there is
equilibrium at a national income (Y) of 100 where consumption (C) is
90 and investment (I) is 10, which is equal to planned investment
(Ip). Then consumption (C) drops to 80 and investment (I) rises to
20, of which 10 is planned (Ip) and 10 is an unplanned increase in
inventory (Iu). Suppose that production will be scaled down by 15 to
75 to anticipate lower demand and to reduce inventory. Unemployment
will then rise and consumption (C) drops to 75.
Businesses do not see a reduction in inventory and scale down production 10 more to 65. Employment reduces again and consumption (C) drops to 70. The next time consumption remains 70 but production remains 65 to sell inventory. Suppose that businesses then reduce planned investments (Ip) to 5 because there is less demand then national income (Y) may stabilise at 75 with a consumption (C) of 70 and planned investments (Ip) of 5.
Price stickiness and deflationary spiral
An interesting observation can be drawn from this calculation. Because people wanted to save more, they end up saving less because incomes dropped. Households intended to save 20 but ended up saving only 5 at the new equilibrium. This phenomenon is called the Paradox of Thrift . The Paradox of Thrift depends on prices being sticky. If all prices including interest rates could adapt immediately to market conditions then this would not happen.
Keynesians assume that prices are sticky. Most notably wages and interest rates do not adjust quickly downwards. Because of money illusion employees will resist lower wages even when prices are lower. Interest rates will not fall as much as is required to make savings (S) match investments (I). According to Keynes, people will hold on to cash and not lend out money, hoping to fetch better interest rates in the future. There is not much downward risk when interest rates are low.
According to Keynesian analysis cutting wages is a bad idea as it will reduce aggregate demand further while insufficient aggregate demand is the cause of recessions in the first place. Furthermore, if wages and prices were falling, people would start to expect them to fall. This could make the economy spiral downwards as those who have money would postpone spending as falling prices makes their money more valuable. Price deflation can make a depression deeper as falling prices and wages made pre-existing nominal debts more valuable in real terms.