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The country of Kingsland is considering the introduction of a compulsory retirement saving scheme. Under this scheme all workers are required to save ten per cent of their annual wages and salaries until they retire. Use the supply and demand model (and a diagram) for saving and investment to explain the likely effects of this scheme on national saving, investment and the real interest rate in Kingsland. Explain the effects on employment of the saving scheme. (You can assume that Kingsland is a closed economy).

Since the level of national savings has increased, I understand how the savings curve shifts to the right and thus decreases the real interest rate and increases the levels of savings and investment in the economy. I am unable to understand how I can relate this back to the level of unemployment in the economy.

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  • $\begingroup$ Disclaimer: I am not a macro expert by any means. How I usually think about these things is if you scales everything down to something that is easier to grasp. If I am saving money, that means I purchase fewer good, which means the store is selling less, making less profit, purchasing fewer products from their suppliers etc etc., which I would assume results in less jobs (since no one is buying) = unemployment goes up. $\endgroup$ – ssn Feb 17 '18 at 22:17
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You need to connect it to the injections, withdrawals and to the output gap in the Keynesian Cross model. As savings increase, planned withdrawals increase in the economy. Consumption decreases, unexpected inventory pile up takes place. Hence firms reduce production and total output is reduced. As output falls unemployment will be more and hence the central bank is going to reduce the interest rate to improve the situation and boost consumption and production.

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Recall that central banks use interest rate to control inflation by inducing spending or saving with decrease or increase in interest rate.

Also,note the theory proposed by the short-run Phillips curve.

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Though this graph has some controversy in terms of its empirical soundness. It is the basis of how we tie interest rate to unemployment.

abstractly you can think of it as a "causal chain" being: $$\text{interest rate}\rightarrow\text{savings rate}\rightarrow\text{spending}\rightarrow\text{inflation}\rightarrow\text{unemployment}$$

Hope this helps.

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A utility-based rationale leads to the conclusion that the savings scheme reduces unemployment. The argument goes as follows:

  1. The savings scheme reduces worker's consumption of goods and services;
  2. A decrease in consumption means workers perceive lower utility for their work;
  3. Lower utility encourages retirement, especially among those who are close to (or past) retirement age;
  4. New retirements translate to an increase in vacant positions;
  5. Therefore, unemployment goes down.
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