Paradox of thrift with example

 PARADOX OF THRIFT

The concept of “paradox of thrift” was first introduced by Bernard Mandeville in the Fable of the Bees(The Fable of The Bees: or, Private Vices, Public Benefits is a book by Bernard Mandeville, consisting of the poem The Grumbling Hive: or, Knaves turn’d Honest, along with prose discussion of the poem. 

The poem was published in 1705, and the book first appeared in 1714. The poem suggests many key principles of economic thought, including division of labor and the "invisible hand", seventy years before these concepts were more thoroughly elucidated by Adam Smith.) in 1714. It was later recognized by several classical economists and became an integral part of Keynesian economics.

The term “Paradox of Thrift” refers to the situation where an increase in savings ultimately reduces the productivity capacity, employment, and saving itself. J.M. Keynes popularized this concept while discussing the great depression of the 1930s. Thriftiness means the tendency of saving more. The classical economists regarded saving as a great social virtue. According to them, investment is determined by saving. They thought that individual savings would create national savings and this national saving would be converted into national investment. Therefore, saving is a virtue or good for the economy.

J.M. Keynes does not accept the concept of savings described by classical economists. Keynes said that savings, which is good or bad depending upon its use. Saving in the forms of hoarding would decrease the consumption of the society. With a decrease in consumption, resulting in the reduction of effective demand and overproduction and unemployment will be consequences in the economy.

If all people in the economy increase saving, it will directly push the total effective demand below. The deficiency in demand for consumer goods also reduces the demand for capital goods (which is derived demand). This will reduce price, profit, and discourage investment and as a result, income, output, employment, and saving itself will be declined. 

Thus, from an individual point of view saving maybe virtue but from an economic point of view, saving is social vice or evil.

According to Keynes, thrift is a public virtue only if the propensity to invest is equally high. Otherwise, thrift is a public vice if the increase in the propensity to save is unaccompanied by an increase in the propensity to invest, i.e., (autonomous investment). Suppose people become thrifty and decide to save more out of a given level of income, given the propensity to invest. This will lead to a lower equilibrium level of income.

How Does the Paradox of Thrift Work?

The paradox of thrift simply works this way: Assume everybody receives Rs. 11,000 of income. They save 50% (5500) and spend the rest (5500). This means everybody is spending Rs. 5500, which supports the demand for products, and in result creates jobs, encourages entrepreneurship, and generates tax for the government.

Now let's assume that everybody decides they need to save more for a better future. They start saving Rs. 7500 out of Rs. 11,000 and spending only Rs. 3500. As a result of the decline in consumption, there is a drop in the demand for goods and services. Businesses can't make a profit, and so they lay off workers, which raises the problem of unemployment and lowers the tax revenue to the government. 

The unemployed people, who now are out of their income, stop spending altogether, which worsens the problem even more. The whole thing continues on a downward spiral. And we can say saving itself has reduced the possibility of saving in the economy and intern weak economic condition.   

Why Does the Paradox of Thrift Matter?

Saving is a good thing, but as Keynes theorized, too much saving is not good for the economy. A certain level of consumer expenditure is necessary to maintain a healthy and sustained economy,  and which ensures the ongoing operation of the economy and thereby people have jobs, and maintain their demand in the economy and providing tax revenue to the government.

Critics of the paradox of thrift said that saving is often investing in companies that use the money to build factories, expand operations, and hire more employees. Accordingly, savings doesn't necessarily halt the economy.

Diagram of Paradox of Thrift

THE PARADOX OF THRIFT

In the diagram the initial saving curve is SS and investment (autonomous investment) curve is II. The economy is in the state of equilibrium (Saving = Investment) at E and the equilibrium level of income is OY. Now, suppose the society decides to become thrifty by reducing consumption expenditure and Increases saving by AE and in result, saving curve shifts upward to S₁S₁ intersecting Investment curve II at E₁.

Due to this reduction in consumption unplanned inventories of businesses will increase and they will cut down production and employment and move to new equilibrium E₁. The figure shows that in the end, planned saving has fallen from AY to E₁Y₁. 

At the new point of equilibrium E₁, investment level, and also realized saving remain the same (E₁Y₁) but the level of income decreased from OY to OY₁. The decline in the equilibrium level of income shows the paradox of thrift as the reverse process of multiplier has worked on reducing consumption expenditure. In fact, Increased saving is virtually a withdrawal from the circular flow of income.