The Paradox of Thrift - Essay Example

As an individual, saving raises the individual's wealth. But a greater desire to save in the 'whole population' may not increase national wealth. This paradox is often known as the "paradox of thrift" as Keynesian developed it. [2] [7] [12] The paradox of Thrift arises in large part from a basic difference in the effect of saving by an individual and the effect of saving by the whole economic system. Individuals do correctly recognize that saving adds to their monetary wealth. But they fail to see that their act of saving may reduce someone else's monetary wealth.

For the economy to prosper as a whole, the way for wealth to rise is through regular investment in plant, equipment and other durables. An act of personal saving makes an individual wealthier, but it will only add to social wealth if the act raises money for current investment. Since it cannot be predicted that regular investment will occur, this can be a source of worry. If an increased desire to save does not generate investment and the creation of social wealth, the standard analysis of saving can lead to incorrect predictions and misleading policy advice.

[2] [6] [12] Initially the saving and investment functions are at equilibrium as shown in the graph above. But when the people decide to save, the point of equilibrium changes to the new point where there is more investment as a result of lower interest rates. So according to this theory, a penny saved must necessar. Since additional saving results in lower spending by the saver, the saver lowers someone else's incomes. Looking at the example below can better explain this scenario.ExampleA person buys everything and spends all his income, $5000, in a specific shop.

One day he decides that he cannot spend anymore and saves the money for his children's education. He raises the saving by $5,000 by reduce his spending of an equivalent amount. Although he gets his saving, he involuntarily lowers the sales and income of the shop keeper that had sold goods and services to him. It was not his intention to lower anyone's income, but it is the inevitable result of his decision to save. Those whose incomes fall cannot accumulate personal wealth in the way that they planned; they become, in a sense, the victims of other peoples' saving: their saving falls as the result of increase in saving by others.

The shop keeper who receives less income will save less. If that shopkeeper who suffered the $5,000 decline in income keeps his spending exactly the same after his income drop as he did before then his saving must fall by $5,000. Therefore total saving in society will not increase at all, even though the one saves $5,000 more. His voluntary choice to save more forced involuntary adjustments on the shopkeeper that reduced his saving by an offsetting amount. Of course, the shopkeeper who suffered the income reduction may not absorb the entire reduction of his wealth with lower saving.

He might also reduce his spending to adjust to lower income, but this action spreads the problem and somewhere down the line some other shop keeper makes up for the decline of $5000. The economy will not reach equilibrium between saving and spending until one or more shopkeepers in the economy have