Some macroeconomic paradoxes: part 1

DSC00228Mainstream macroeconomics (the study of the economy as a whole) places great importance on ‘microfoundations’. The microfoundations of macroeconomics start from the behaviour of isolated individuals, or more accurately a single representative individual, and generalise his or her behaviour in order to derive macroeconomic outcomes.

More heterodox (non-mainstream) schools of thought hold that holism should not be so neglected. More holistic theories suggest that emergence is a characteristic of social structures and forces: the whole cannot necessarily be reduced to the sum of its parts and there is therefore a place for starting analysis at the macroeconomic level.

If you have studied economics, you may be familiar with the paradox of thrift as an example of a fallacy of composition. But there are other such paradoxes, emphasised particularly by post-Keynesians. In this and the next post, I will briefly outline them. Please note that I am not attempting to prove them empirically, but simply explain the ideas as possible economic outcomes. These ideas are taken from Marc Lavoie’s textbook Post-Keynesian Economics: New Foundations (2014), Ch.1, p.18-22.

  • The paradox of thrift. An increase in the propensity to save will reduce output. One or even many individuals may increase the proportion of their income that they save and do not spend. However if the majority of the population of an economy do so, overall consumption will fall, reducing output. This may even lead to a fall in the absolute level of savings if the economy shrinks, so that an increase in desired saving leads to a fall in actual saving.
  • The paradox of costs. This holds that a decrease in real wages will not increase the profits of firms and will instead lead to a fall in employment. One firm can achieve higher profits by reducing its wage bill. However, if all firms attempt to do the same, consumption will fall at the macro level, reducing sales, and from there the rate of profits.
  • The paradox of public deficits. This theory shows that an increase in the government’s deficit can increase firm profitability. The extent of this will vary depending on the impact of a higher deficit on the balance of trade in an open economy. It also may not hold in the longer term, as a boost to profits in the short-term may reduce the incentives for firms to restructure or prevent weaker firms going bust, thereby hampering structural change. But it remains a possibility.
  • The paradox of profit-led demand. This idea suggests that if overall real wages in an economy are reduced to reduce prices, this can lead to a boost to demand via net exports as the country becomes more competitive internationally. However if all countries try to do the same, global consumption will fall, reducing demand and output. It is impossible for all countries to become more competitive against each other, since the world economy is a closed system. While one country can benefit from real wage reductions, other things being equal, the world economy as a whole cannot. A good example of this paradox is the Eurozone since 2000, with Germany as the economy reducing wages to increase the competitiveness of its exports.

(Update: part 2 of this post can be found here.)

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One thought on “Some macroeconomic paradoxes: part 1

  1. Pingback: Some macroeconomic paradoxes: part 2 | The Political Economy of Development

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