Paradox of Thrift
Paradox of Thrift
The paradox of thrift is also known as the paradox of saving.
The paradox of thrift states that during a recession, an increase in planned savings (the marginal propensity to save increases) can cause actual savings and investment to decrease.
This can prolong or deepen a recession.
It is not unusual for people to reduce consumption spending in recessionary times. Obviously, those who have lost disposable income due to the recession will have less money to spend. But others will often reduce consumption also, as a hedge against the increased possibility of a future loss of income.
Since consumption plus savings equals disposable income, and the marginal propensity to consume (MPC) plus the marginal propensity to save (MPS) always equals one, then a decrease in consumption at a given level of disposable income will mean that savings will increase.
The paradox of thrift is a theory which basically says that in such a situation, the level of disposable income will not stay the same. In fact, the increase in the MPS will cause the level of disposable income to decrease.
This means that the expected increase in savings from the increase in the MPS will not occur. In fact, disposable income could lower to the point where a planned increase in savings could actually reduce savings.
With savings increased at the expense of consumption, a decrease in consumption will decrease aggregate demand. With aggregate demand decreasing, businesses will not be able to sell as much output.
This will further lower investment, output, and jobs. Income will decrease as a result.
As income decreases, consumers will have less disposable income, less money available for both consumption and savings.
The actual amount of savings can thus be decreased due to a planned increase in savings. This is the paradox of thrift.
The paradox of thrift is actually a fallacy of composition.
The decision to increase savings is an individual decision, made on a microeconomic level. The individual can make a personal choice to increase savings. The resulting decrease in savings from the paradox of thrift is a macroeconomic result, the cumulative outcome of individual actions. Savings may decrease in the overall economy - for savers in general - not necessarily for any specific individual who chooses to increase savings.
The paradox of thrift can be shown graphically on a diagram of leakages and injections into the circular flow model of GDP.
For this purpose, leakages are considered to be savings, while injections are considered to be investment.
Such a diagram would have the level of savings / investment on the vertical axis, and the level of income (or real GDP) on the horizontal axis.
The savings (leakages) curve would slope upward. Normally, the investment (injections) curve would slope downward. Equilibrium is where these two curves intersect. An increase in the MPS would be shown as an upward (leftward, not rightward) shift in the savings curve. A resulting increase in investment would be shown as an upward (and rightward) shift in the investment curve. The two shifts together would result in an increase in real GDP.
But with the paradox of thrift, the resulting increase in investment would not occur. This would be shown as a horizontal, not a downward sloping, investment curve. An upward shift in the savings curve, combined with no shift in the horizontal investment curve, would result in a decrease in real GDP.