Question

True, False, Uncertain, Explain (intuitively and graphically) Does paradox of thrift result still hold true when in the IS-LM framework? Use the case where consumer confidence is falling. How might this affect private savings and investment spending. Hint: your answer can be motivated in part by the I^D = S_n identity.

Answer 1

Paradox of thrift is the result where individual efforts to save more results in a decline in aggregate savings. This happens because when everyone is saving more and consuming less, aggregate consumption in the first period falls. With multiplier effect, national income fall and this results in a reduction in both aggregate consumption and aggregate saving of future period.  

In case of IS-LM model, this criteria may not hold true. Fall in consumption spending will shift IS to the left reducing interest rate. This will encourage investments. On the other side, private savings are increased (not in response to interest rate, but otherwise). Hence it might be possible that both private savings and investment increase in the short run, leading to an increase in output. IS will then shift back to its original level and the paradox may not work.