Question

The paradox of thrift is an idea that was popularized by the early 20th century economist John Maynard Keynes. It says that when individuals try to save more (such as during uncertain economic times), it will lead to a fall in aggregate demand and hence in income. Keynes was arguing that what seems to be a good idea – i.e. thrift – produces a bad outcome – i.e. a fall in income.

-Using the equation describing goods market equilibrium, explain how Keynes arrived at his conclusion.

-Using the graphical description of goods market equilibrium that focuses on savings and investment, does the same conclusion hold? How so?

-What do you think? Is it a true or false paradox?

Answer 1

1. Describing paradox of thrift in equation:

Let initial consumption function be:

C = 200 + .8Y

Let autonomous investment be 300 ------- (i)

Therefore, equilibrium level of output and income will be,

Y = 5 (200 + 300) = 2500 --------- (ii)

[multiplier is 5 i.e. (1/ 1-.8 = 5)] formula for calculating the multiplier is 1/ (1-b)

Thus aggregate consumption will be:

C = 200 + .8(2500) = 2100 -------- (iii)

Aggregate savings will be:

S = (-200) + (1 - .8) (2500) = 300 -------- (iv)

Note that at this stage, investment = savings [(i) = (iv)]

Let a new consumption function with higher savings (therefore lower consumption) be:

C = 200 + .75Y

Let autonomous investment be same at 300 ------ (v)

Equilibrium level of output and income will be:

Y = 4 (200 + 300) = 2000 ---------------------------------(vi) New multiplier is 4 ---- i.e. (1/ 1-.75 = 4)

New Aggregate consumption will be;

C = 200 + .75 (2000) = 1700 --------------- (vii)

New Aggregate savings will be ,

S = (-200) + (1-.75) * 2000 = 300 ----------(viii)

Thus we see that saving is still equal to investment before and after the savings increased. [ refer to (i), (iv), (v) and (viii) above]

But output (and therefore employment) is lower. [compare (ii) and (vi) as well as (iii) and (vii) above]

Thus the increased saving rate not only did not result in increased aggregate savings, it also lowered output and income.

paradox of thrift is truly a paradox.

2. Graph:

  

Initial saving is S1. Ip is the induced (planned) investment line (it is dependent on income, not autonomous). S1 intersects Ip at E1, where S=I (savings are equal to investment). At this point, Y1 is the national income (level of output, therefore level of employment).

When it is decided to save more, S2 is the new savings. It intersects Ip at E2. At this point, new level of national income (output, therefore employment) is at Y2. We see that the corresponding point on y-axis representing savings in lower than the initial savings. On x-axis, we can see the decreased volume of savings from E1Y1 to E2Y2.

This is paradox of thrift.

3. I think it is a true paradox because this theory makes sense. When savings are more, the part of the disposable income left for consumption will be less. (because Income = Consumption + Savings). As a result of reduced consumption expenditure, there will be less demand for goods. Producers' stock will lie unsold. This leads to unemployment (producers need less workers/ resources now) resulting in a fall in the level of income.

Thus more savings will lower the level of output and employment.