# Relationship between Real Interest Rate and Employment

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.

• 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.
– ssn
Commented Feb 17, 2018 at 22:17

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.

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.

• I would say, after checking your link, that you are not alone in questioning the P. curve. In general, I think the thing is dead.
– 123
Commented Apr 7, 2020 at 16:26

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.

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.

Simplifying assumption: workers aren't currently saving as much as 10%, so this program actually increases the savings rate.

In the long run we'll see a shift in the composition of economic activity. There will be less money going into current consumption (e.g. I'm less likely to go to the movies this week), but more going into investment (e.g. I'm more likely to get a small business loan to help me start a new business). This means short run losses for some industries (movie theaters, cars--businesses selling things for consumers to enjoy right now) but gains for others (machine shops, B2B services--business selling things that help us build/invest in new stuff).

I would expect a short run increase in unemployment as this structural shift occurs. A boat salesman is going to lose his job, and it's going to take some time for him to find a new job selling accounting services to businesses.

In the long run, unemployment rates should go back to something like the previous normal, although as Iñaki Viggers points out, there will also be changes in labor force participation. All else equal, labor force participation should decrease.