Paradox of Thrift

Macroeconomics Discussion Session Exercise #6

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

The attempt by an economy as a whole to save more, not only will not increase its

savings, but may throw the economy into a recession. This is because when individuals try

to save more, they consume less. The decline in consumption will lead to a fall in business

sales, which causes producers to cut back production and lay people off, which leads to a fall

in income, which causes consumption and savings to both decline. Another way of looking

at it is the increase in the marginal propensity to save means a decrease in the marginal

propensity to consume, and therefore a fall in the value of the multiplier. Given autonomous

spending, the new macroeconomic equilibrium associated with the new value of the

multiplier will be lower, meaning lower output, income, and employment. In both of these

cases, savings will not have increased. In Keynes, since investment determines savings, the

only way savings can change is if investment changes. Savings is not the source of growth, it

is the result of growth.

Start with an economy in which a = $100, b = .8, and I = $300.

Ye = 1/(1-.8) x (100 + 300)

= 5 x 400 = $2000

Ce = 100 + .8 (2000) = $1700

Se = -100 + (.2) 2000 = $300

Se = I = $300

Now suppose the President announces we need to save more so the economy can grow, and

people respond by saving a nickel more out of every dollar. So the mps rises from .2 to .25,

meaning the mpc falls from .8 to .75. What happens to the economy as a whole?

Ye = 1/(1-.75) x (100 + 300)

= 4 x 400 = $1600

Ce = 100 + .75 (1600) = $1300

Se = -100 + (.25) 1600 = $300

Se = I = $300

Consumption falls from $1700 to $1300. Output and income fall from $2000 to $1600,

meaning a recession (or depression). Saving is unchanged at $300.

This is an example of the paradox of thrift, which is a case of the fallacy of composition:

one individual can increase...