Paradox of Thrift

The Paradox of Thrift considers the negative impact of personal savings on an economy. British economist Maynard Keynes popularized the theory. Such scenarios are witnessed during a recession when consumers cut consumption to save more.

This paradox occurs when a huge population ends up saving all at once. Consumers start investing in financial markets or assets. As a result, cash flow falls to extremely low levels. Businesses run out of working capital and halt production. Ultimately this leads to increased unemployment.

• The paradox of thrift explains how people tend to save more in times of recession, creating a huge market cash-flow gap. Ultimately, it jeopardizes a nation's economy.
• English economist John Maynard Keynes introduced the term in The General Theory of Economics, published in 1936. However, non-Keynesian economists condemned the theory.
• A reverse paradox is also observed. When people earn more, they tend to consume more, leading to economic growth.
• Savings do not cause much harm in a post-globalization world. When a nation experiences a decrease in local demand, it can always export goods overseas.

The paradox of thrift occurs when a large percentage of the population saves more and consumes less. When consumers start saving more, consumption levels fall, and as a result, the total output of an economy diminishes. This consumer behavior is witnessed during a recession—consumers save more to prepare themselves for the worst. It is a vicious cycle; the decrease in consumer spending further triggers a reduction in production. Ultimately, the economic recession worsens.

• In the above graph, the Y-axis represents savings, and the X-axis represents income. Curve SS provides the point of equilibrium at point E.
• But If society decides to reduce consumption patterns to increase savings, there is a shift from curve SS to S₁S₁. As a result, the equilibrium point now shifts from E to E₁.
• Further, reduced savings results in unplanned inventories—businesses reduce production—employment levels go down.
• The graph shows a fall in income from OY to OY₁. An increase in savings causes this fall.

During a recession, young people belonging to the working class prefer to stay with their parents instead of living in their own houses. As a result, there is a fall in consumption: rent, utilities, etc. Simultaneously, there is an increase in savings. But again, such consumer behavior intensifies recession by causing a fall in demand.

On average, a US citizen earns $4000 a month. In addition, each individual saves about $1000 by opting for one of the investment options. Also, average monthly expenses for an individual are about $2500. For emergencies, individuals possess about $500 in cash.

If an individual decides to increase savings from $1000 to $2000 every month, the monthly budget falls from $2500 plus $500 in cash to $1750 plus $250 in cash.

But that is just one individual. Macroeconomics charts the behavior of the masses. It tracks macroeconomic factors like the uncertainty of unemployment, recession, and reduced business profits. When such a change in consumption patterns occurs in society, it triggers a vicious cycle. Demand falls—business output falls—more unemployment—recession increases. The recovery time for such an economy increases.

It is a Snowball effect. The individual choices of one individual create a massive impact because many individuals opt for the same strategy. At an individual level, this decision helps them avoid future financial issues. But this comes at the cost of current consumption. The paradox of thrift was witnessed during the great depression of 1929 and the 2008 recession in the U.S.

Neoclassical economists criticize the concept for the following reasons.

#1 - Demand and Supply’s Effect on Price

If demand decreases, supply also increases, causing the price to rise (to recover demand). But the paradox concept does not consider the equilibrium of demand and supply. Rather it assumes that the price of products will remain unchanged.

#2 - Savings and Lending Capacity

An increase in savings increases banks’ ability to lend—borrowing increases. This change offsets the decrease in consumption. This criticism highlights consumers’ liquidity preferences. If consumers save in cash, then savings harm the economy. But if consumers deposit savings in a bank, the damage gets canceled.

#3 - Closed Economy

Savings do not cause much harm in a post-globalization world. When a nation experiences a decrease in local demand, it can always export goods overseas. In response to criticism, many theorists argue that the global economy is a closed system—many nations cannot export.

The inability to export could be due to the lack of transport channels, inferior product quality, or the inability to compete with the international market's pricing.

#4 - Savings and Capital Investment

To optimize production, businesses need savings and capital investment. So actually, savings boost production. In real-world scenarios, production depends on variables like technology and the level of competition. Upgrading technology also requires substantial capital investment; savings can facilitate that.

This has been a guide to What is Paradox of Thrift and its meaning. Here, we explain it in detail with examples & offer criticism of it. You can learn more about it from the following articles -

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