National income is consumption plus investment, which is reflected in the equation National Income (Y) = Consumption (C) + Investment (I). If consumption drops, there is more money in the form of savings available for investment. At the same time businesses need to reduce production so the investment demand for money will also drop (see figure 3).
figure 3: savings supply and investment demand
According to classical economists , people save money in order to have more in the future. Because people have a time preference and prefer present consumption above future consumption, they only postpone consumption if interest rates are high enough.
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.
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
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.