(UPSC Economics Optional 2014) Question 5:

Explain the paradox of thrift.

Click on this interesting 60 second video on paradox of thrift here

Paradox of thrift:
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. For 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.

 Fallacy of composition: Assume that what seems to be good for an individual within the economy will be good for the entire population. Thrift may be good for an individual by enabling that individual to save for a "rainy day", and yet not be good for the economy as a whole.This paradox can be explained by analyzing the place, and impact, of increased savings in an economy. 

If a population saves more money (MPS increases across all income levels), then total revenues for companies will decline. This decrease in economic growth means fewer salary increases and perhaps downsizing. Eventually the population's total savings will have remained the same or even declined because of lower incomes and a weaker economy. This paradox is based on the proposition, put forth in Keynesian economics, that many economic downturns are demand based. Hypothetically, if all people will save their money, savings will rise but there is a tendency that the macroeconomic status will fall.

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