The Paradox of Thrift

thrift

The paradox of thrift is a Keynesian concept, revolving around Keynes’ theory of aggregate demand and its effects on the economy. When the economy is not doing well, i.e. not growing, individuals tend to save more on the basis that they may have a smaller income in the future, essentially saving for a rainy day. However a problem arises when large numbers of people within an economy choose to save their money as opposed to spending it, as this leads to a reduction in consumption and therefore aggregate demand. People buy less, and so companies do worse, leading to a ‘reverse’ multiplier effect that reduces the income of everyone within the economy.

 Therein lies the paradox—that when large numbers of people do what individually seems a rational action, it actually has a negative effect on all of them, indirectly via the negative effect their actions have on the economy. It links to the ‘fallacy of composition’, that being the idea that the sum of the parts is not necessarily equal to the whole. The positive individual effects of saving money are not replicated on a large scale, but rather quite the reverse.

 Whilst it might be said that individuals storing money in banks would not have the aforementioned effect, due to the fact that money stored in banks is lent out and invested,, this does not take into account the likelihood that banks in such an economic climate are also cautious with their money and unwilling to lend freely.

 Other criticisms of the paradox of thrift include the concept that as demand drops, in this case due to a high savings ratio, prices also drop in accordance with a simple supply-demand diagram, and allow the market to regain equilibrium. There’s also the possibility that savings can be invested abroad, perhaps in order to stimulate net exports, and this would not have the aforementioned effect, but instead help the economy to recover from the recession. However on a global stage, the paradox of thrift is not affected by this possibility, as there’s nowhere outside of the global economy for exports to go to; the global economy is a closed system.

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