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The Fallacy of Composition

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by

Avinash Shah

on 17 March 2014

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Transcript of The Fallacy of Composition

What does it mean?
As Economists you must be wary of extrapolating from your own personal situation to society and the economy as a whole. If you do so you this is likely to lead to the problem of the
FALLACY OF COMPOSITION
An Example of a fallacy of composition
Fiscal Austerity and the Fallacy of Composition
What might be rational or desireable for individuals is not necessarily desireable for society as a whole.
The Paradox of Thrift: An individual can increase
his/her savings by reducing consumption. Assuming that there is no change in their income, savings will increase. However, what if everyone also tried to increase their savings by reducing consumption? The large drop in AD (made larger still due to the negative multiplier effect) will cause Real GDP and employment to fall, and therefore in total, individuals' capacity to save will fall. Put together, individuals attempts at saving will reduce their capacity to save.
If an individual country's government reduces government expenditure and raises taxation in order to improve the budget balance it may be entirely rational and desireable in the long run.

HOWEVER there are two problems to consider.....
The Fallacy of Composition
1. What if the private sector is also trying to pay down debts? Private demand (Consumption and Investment) will be falling together with Government demand. This may cause a large multipled fall in Real GDP and employment making it harder for the government AND the private sector to reduce debts at the same time.

2. What if all other major countries governments are also doing the same? What is the effect on global demand? If global demand falls, then through the multiplier effect each country's AD will fall. The reduction in Real GDP will worsen the budget balance as the Automatic Stabilisers kick in. So Fiscal Austerity can be self defeating if every country is embarked on the same policy at the same time.
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