Question

Explain the paradox of thrift and demonstrate it using a numerical example.

Outline Keynes’s critique of the neoclassical theory of saving and investment.

Answer 1

* The paradox of thrift is a concept that refers to contrasting implications of savings to households and to the economy as a whole. To explain, saving is considered a virtue by households as they provide a protective shield against bad spells, but it is treated as harmful by the economy at it retards the process of income generation when too much of money is saved. An example to mention is that when people tend to save more, they spend less, and less consumption will lead to fall in business sales which causes producers to cut back production. This will lead to fall in income which causes consumption and saving to decline. Given these conditions, the multiplier will be lower, meaning lower output, income and employment.

* The neo-classical economists called for higher savings assuming that all the savings will automatically be invested. Keynes was of the opinion that savings are not automatically invested, since those who invest are different from those who save. He pointed out that saving is a leakage form the economy, a form of hoarding or money not spent. He termed this process as liquidity preference. Keynes concluded that higher savings leads to decrease in consumption and of effective demand at macro-economic level.

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