The paradox of thrift, also referred to as the paradox of savings, is an economic theory or paradox of economics which states a rise in independent saving leads to a decrease in aggregate demands and thus a decrease in gross output, leading to economy slowdown and less overall savings.
KEY TAKEAWAYS:
1. The paradox of thrift is a theory by economist John Maynard Keynes. It argues that saving money isn't always good for the economy in the short term, especially during a recession. In these situations, sometimes spending is more important to keep the economy going.
2. Say's Law: Critics argue the paradox overlooks the idea that people's spending eventually becomes someone else's income. So, more saving can lead to more investment in things like machinery and factories, which can boost future production.
3. Inflation/Deflation: They also say the theory forgets about inflation (rising prices) and deflation (falling prices). If everyone saves more and prices fall, it might not be so bad as Keynes thought.
4. Role of Government Policy: To counteract the paradox, government policies might encourage spending during economic downturns, such as through stimulus packages or tax cuts.
The first conceptual description of the Paradox of Thrift may have appeared in Bernard Mandeville’s 1714 work, The Fable of the Bees. Mandeville argued that increased spending, rather than saving, was essential for prosperity. John Maynard Keynes later credited Mandeville for this concept in his 1936 book, The General Theory of Employment, Interest, and Money.
What is Paradox of Thrift?
The paradox of thrift, a concept introduced by John Maynard Keynes, argues that during a recession, the typical advice of saving more can actually hurt a country's economy. Keynesian theory suggests the opposite - increased spending, risk-taking, and less saving are the keys to recovery.
Here's why: In a recession, the economy isn't producing at full capacity. Businesses have unemployed resources like land, labor, and capital. Keynesians believe consumption, or spending, drives economic growth. While saving more might seem sensible for individuals during tough times, it's the wrong prescription for the larger economy.
Imagine everyone cuts back on spending. Businesses will sell less, leading to production cuts and layoffs. This decrease in income further reduces spending, creating a downward spiral. This disconnect between what's rational for individuals and what's good for the whole economy is the crux of the paradox of thrift.
A real-world example is the Great Recession following the 2008 financial crisis. While American households increased their savings rate from 2.9% to 5%, the Federal Reserve lowered interest rates to encourage spending and stimulate the economy.
Examples of Paradox of Thrift
Here’s a simple way to understand the paradox of thrift in Economics:
- People Save More: Imagine that during tough economic times, people decide to save more money and spend less.
- Less Spending: When everyone spends less, businesses sell fewer goods and services.
- Businesses Earn Less: With fewer sales, businesses make less money and might have to cut costs by laying off workers or reducing wages.
- Less Income for Workers: As people lose jobs or earn less, they have even less money to spend.
- Economy Slows Down: This cycle continues, causing the economy to slow down and shrink.
- Savings Don't Increase: In the end, because people are earning less, they might not be able to save as much as they hoped.
In a nutshell, even though saving money is good for an individual, if everyone does it at once, it can lead to negative effects for the whole economy, making it harder for everyone to save.
Concept Overview
The idea here is to show you that when consumers try to save more, it can paradoxically lead to lower overall savings in the economy. We use a goods market model with an accelerator effect on investment to demonstrate this.
Model Setup
Consumption (C):
C = c0 + c1(Y - T)
Investment (I):
I = b0 + b1Y
Direct Proof
Investment equals total savings:
I = S + (T - G)
Therefore:
S = I - (T - G)
A fall in consumption Δc0 < 0 leads to a decline in output ΔY < 0, which in turn reduces investment:
ΔI = b1ΔY
Given that taxes (T) and government spending (G) are fixed, the change in private saving equals the change in investment, which is negative. Thus, a fall in consumption leads to a fall in private saving.
Intuitive Proof
Output equals demand:
Y = (1 / (1 - c1 - b1))(c0 + b0 - c1T + G)
A decrease in Δc0 < 0 leads to a decline in output:
ΔY = Δc0 / (1 - c1 - b1)
Private saving (S) is given by:
S = (Y - T) - C = (Y - T) - c0 - c1(Y - T) = -c0 + (1 - c1)(Y - T)
The change in private saving ΔS is:
ΔS = Δ(-c0) + Δ[(1 - c1)(Y - T)]
The indirect effect is:
Δ[(1 - c1)(Y - T)] = (1 - c1)ΔY = ((1 - c1)Δc0) / (1 - c1 - b1)
Therefore, the total effect on saving is negative:
ΔS = -Δc0 + ((1 - c1)Δc0) / (1 - c1 - b1) = (b1Δc0) / (1 - c1 - b1) < 0
Fall in Government Purchases
Direct Proof
A rise in public saving, from reduced government spending ΔG < 0, leads to a decline in output ΔY < 0, and hence a decline in investment:
ΔI = b1ΔY
ΔI = b1ΔY < 0
Thus, a deficit reduction is bad for investment.
Intuitive Proof
The fall in government spending ΔG < 0 leads to an increase in public saving:
Δ(T - G) = -ΔG > 0
This fall also leads to a decline in output:
ΔY = ΔG / (1 - c1 - b1)
Private saving (S) is:
S = -c0 + (1 - c1)(Y - T)
Therefore:
ΔS = (1 - c1)ΔY = ((1 - c1)ΔG) / (1 - c1 - b1)
The fall in private saving is larger than the rise in public saving. Overall effect on total saving, and hence investment, is negative:
ΔI = ΔS + Δ(T - G) = ((1 - c1)ΔG) / (1 - c1 - b1) - ΔG = (b1ΔG) / (1 - c1 - b1) < 0
Increase in Net Taxes
Direct Proof
Similar to the above section on government purchases.
Intuitive Proof
A tax increase ΔT > 0 leads to an increase in public saving:
Δ(T - G) = ΔT > 0
This leads to a fall in private saving through:
- A direct reduction in disposable income.
- An indirect reduction in output.
Output change:
ΔY = -c1ΔT / (1 - c1 - b1)
Private saving (S) is:
S = -c0 + (1 - c1)(Y - T)
Therefore:
ΔS = (1 - c1)(-ΔT + ΔY) = (1 - c1)(-c1ΔT / (1 - c1 - b1)) - (1 - c1)ΔT
Overall effect on total saving and investment is decreasing:
ΔI = ΔS + Δ(T - G) = -b1c1ΔT / (1 - c1 - b1) < 0
Limitations of the Paradox of Thrift
The paradox of thrift highlights a potential downside to increased saving during a recession. However, the theory isn't without its limitations. Here are what you need to know:
Ignoring Capital Goods: The theory relies on a simplified economic model that doesn't account for capital goods like machinery and factories. Say's Law, which states that supply creates its own demand, emphasizes this point. Increased savings can lead to more investment in capital goods, which can ultimately boost future production and economic growth. The paradox of thrift, by focusing solely on immediate consumption, overlooks this potential benefit.
Inflation and Deflation: The theory assumes stable prices. However, economic conditions can cause inflation (rising prices) or deflation (falling prices). If people save more during a recession and prices fall, it might not be as detrimental as Keynes predicted. Lower prices could encourage spending, potentially mitigating the negative effects of the paradox. Conversely, if increased spending during a recession leads to inflation, it might cancel out the intended benefits.
The Role of Banks: The paradox of thrift assumes that increased savings simply sit idle. However, banks play a crucial role in the economy by lending out saved money. When people save more, banks can offer more loans to businesses and individuals, potentially stimulating investment and economic activity. This aspect of the financial system is not fully captured by the theory.
Keynesian Rebuttal: John Maynard Keynes acknowledged some of these limitations. He argued that Say's Law wasn't always accurate and that prices might be too inflexible to adjust quickly to economic changes. However, the debate about "sticky prices" continues among economists. Additionally, Keynes' interpretation of Say's Law has been widely criticized as inaccurate.
The Bottom Line
During the COVID-19 pandemic, the personal savings rate surged to nearly 30% in 2020, with U.S. households collectively holding approximately $2.3 trillion in savings. However, these figures began to decline by the end of 2021, indicating a shift in saving behaviors possibly influenced by changes in economic conditions, government policies, and consumer confidence.
Say's Law, often credited to French economist John Baptiste Say, asserts that the act of producing goods and services automatically generates income and purchasing power, creating a demand for other goods and services in the economy.
Say succinctly captured this idea in 1803, stating that a product, upon creation, immediately stimulates demand for other products equal to its own value. This principle has been influential in shaping economic thought and understanding the relationship between production, consumption, and overall economic activity.