Paradox Of Thrift

Definition

The paradox of thrift is a paradox of economics. The paradox states that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower total saving. The paradox is, narrowly speaking, that total saving may fall because of individuals’ attempts to increase their saving, and, broadly speaking, that increase in saving may be harmful to an economy. Both the narrow and broad claims are paradoxical within the assumption underlying the fallacy of composition, namely that what is true of the parts must be true of the whole. The narrow claim transparently contradicts this assumption, and the broad one does so by implication, because while individual thrift is generally averred to be good for the economy, the paradox of thrift holds that collective thrift may be bad for the economy.

Paradox Of Thrift

What is the ‘Paradox Of Thrift ‘

The Paradox of Thrift, or paradox of savings, is an economic theory which posits that personal savings are a net drag on the economy during a recession. This theory relies on the assumption that prices do not clear or that producers fail to adjust to changing conditions, contrary to the expectations of classical microeconomics. The Paradox of Thrift was popularized by British economist John Maynard Keynes.

Explaining ‘Paradox Of Thrift ‘

According to Keynesian theory, the proper response to an economic recession is more spending, more risk-taking and less savings. Keynesians believe a recessed economy does not produce at full capacity because some of its factors of production — land, labor and capital — are unemployed.

Circular Flow

Keynes helped revive the so-called “circular flow” model of the economy. This theory says an increase in current spending drives future spending. Current spending, after all, results in more income for current producers. Those producers rationally deploy their new income, sometimes expanding business and hiring new workers, each of whom earns a new income which, in turn, may be spent.

Problems

The circular flow model ignores the lesson of Say’s Law, which states goods must be produced before they can be exchanged. Capital machines, which drive higher levels of production, require additional savings and investment. The circular flow model only works in a framework without capital goods.

Paradox Of Thrift

Definition