Economics Online Tutor
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 that 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. Incomes will decrease as a result.

As incomes decrease, 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 increase savings by personal choice. 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
chose 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 can be considered to be savings, while
injections can be 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.
This page, along with additional commentary, was posted on the "Economics Online
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