The Paradox of Thrift

Economic concept that if everyone tries to save an

increasingly larger portion of his or her income, they would become poorer instead of richer. This is because the economy will slow down from reduction in demand and the very same people would lose their jobs. This theory, however, applies mainly to Keynesian economics where increased savings represent a diminishing circular flow of income.

 Many people believe that higher savings lead to higher income.

In the present model, we get a result that is

contrary to this belief. In other words, equilibrium income falls when people want to save more. Idea: the attempt to achieve higher savings may reduce equilibrium income

 This is an example of the fallacy of composition Thriftiness, while a virtue for the individual, is

disastrous for an economy Given I = I Given S = S + sY OR S = -C + (1-c)Y Now, suppose S Will Ye increase as well?

A rise in thriftiness causes a decrease in national income but no increase in realised saving.

S=S +sY S= S+ sY Excess Supply

I=I

Ye

 If a rise in saving leads to a reduction in interest rate and hence an increase in investment (Think of the loanable fund market), national income may not decrease Ye will increase if I increase more than S Ye will remain the same if I increase as much as S Ye will decrease if I increase less than S

I > S

S=S +sY S= S+ sY I=I I=I

Ye

I = S

S=S +sY S= S+ sY I=I I=I

Ye

=Ye

I < S

The reduction in Ye is less than the case when I does not increase

S=S +sY S= S+ sY I=I I=I

Ye What about the case if I is an induced function of Y?

8

S,I

S1 S0 I

Fig 9.7

Savings (in pesos)

Y1

Y0

Income (in pesos)

The Paradox of Thrift