Question

4. The paradox of thrift states that an attempt of households to save more may result in them ending up saving less. Could this be the case in the IS-LM model? Answer by finding the multiplier for the effect of an autonomous increase in saving on the equilibrium level of saving, and explain the result.

Answer 1

the paradox of thrift states that when people save more in the current period they will save less in the subsequent periods because increase in saving will reduce the consumption expenditure. as we know total income is devided between consumption and savings, if savings increases consumption would go down and vice versa. so if consumption goes down then the total money supply in the economy will go down and that will happen because decrease consumption will make a glut in the economy and investors will stop investing which will reduce employment rate and will reduce the income level and in the next period due to reduced income persons consumption as well as savings will decline.

in case of IS-LM model framework we can interpret it as, the reduced consumption expenditure, which is a result of increased autonomous saving will lead to reduced investment which will shift the IS curve to the left. as the multipler effect works in case of consumption it will woek backward in case of savings. it will reduce the level of income if savings increases and then the supply of money will also decrease. as a result the LM curve will shift backward as well and the new equilibrium will reduce the total output/income keeping the rate of interest constant. the reduced income will result in decrease in equilibrium level of saving.