Save or Spend: Connecting the Personal to the Macro

This post relates to the following Keystone Economic Principles:
1. We all make choices.
3. Our choices have consequences.
9. Prices are determined by the market forces of supply and demand…and are constantly changing.

Earlier this week, I ran across a couple articles that provide the basis for discussion. Together, they did a good job of explaining how personal budgets and choices are reflected in the larger, macro-economy. They lend themselves well to both personal finance and macroeconomics. Subsequently, I ran across another couple of pieces (HT to Planet Money) that could be used with the same articles to flesh out a classic debate within economics.

The first two articles were in Monday's edition of The Wall Street Journal. The first article was about the choices families were making in their consumption, as a result of the economic downturn. Cutting spending as income falls - which may seem obvious - is not always easy to do. And the families in the story provide good background for discussion in a personal finance course. But what's the larger impact of deciding to save rather than spend? Does cutting back on one's budget really impact the macro economy? That's the point of the second article from the Journal. It provides a clear explanation of how not spending can create further problems in a weak economy.

That idea provides the segue to the other two pieces. The idea that reducing spending in hard times acts to slow the economy further; which instills fear for the future and provides additional incentive to save and not spend is referred to as a "liquidity trap." Recent Nobel Prize winner, Paul Krugman, provides a well-written and classic explanation of the dangers of a liquidity trap in this piece from The New York Times.

But not everyone believes that explanation. There's a good counter-argument in this piece at the Mises Institute blog. The idea presented is that reduced consumption is not so much the cause as an effect. However, what seems to be missing for me is an explanation of role of the effect in generating a downward spiral. Personally, if we hold that consumption spending is two-thirds or more of domestic spending, any reduction in consumption must have an impact on GDP. While consumers may not cause a recession, their decisions may serve to amplify it.

I'd be interested in hearing your take on these articles, or the responses of your students.