Monopolistic Competition, Precautionary Savings, Coordination Failure

By using the concept of precautionary savings instead of the life-cycle hypothesis in a model of monopolistic competition, this paper shows that recessions can occur even when prices are flexible. In this model, when buying goods, consumers face trade-offs not only with purchasing other goods but also with saving. Producers consider this and strategically determine prices and outputs. In this case, if consumers’ precautionary saving motive increases, coordination failure occurs and the aggregate supply decreases. In simple words, this is because the demand curve shrinks to the left instead of down.