Paradox of Thrift (Saving is
a vice not virtue)
The classical economists considered
saving to be a great virtue. They encouraged hard-work, maximum earning and minimum
spending on consumption. They advised people to accumulate for future by
maximizing earning and minimizing expenditure on consumption. Thinking
aggregate savings as simply and aggregation of savings by individual members of
the Community, they come to the conclusion that thriftiness improves the future
of society. They also recognized that domestic saving was the major source of
capital formation which is very necessary for economic progress.
However, Keynes pointed out that
when we consider the community as a whole, we can no longer assume that when
community reduces its consumption, its income remains unchanged. The volume of
saving defends upon the level of national income and the saving of the
community can increase only when the total income of the community increases.
Since expenditure of one person constitutes the income of another person,
increase in savings of some individuals will lead to a decline in the incomes
and hence expenditures of certain other individuals. Further, a decrease in demand
for consumption goods in the economy will decrease the demand for capital
goods. The decline in demand for consumption goods as well as for capital goods
would lead to a decline in their prices and hence in profits. Declining Profits
would discourage investment and thus result in a decline in income, output and
employment. In short, a general reduction in consumption would cause a general defficiency
of effective demand, leading to a lower level of equilibrium with considerable
unemployment. Thus, though saving is a virtue for an individual, it is harmful
for the society as a whole. Thus, 'saving is a vice but not virtue.
So, saving decreases effective
demand in the economy resulting a decrease in the price and profit. As a
result, investors will be discouraged to invest. This will further decrease the
employment, production and income which in turn decreases the saving. This will
convert the saving into social evil. So, in the beginning saving is a virtue to
the individual but to the society and the nation it will be harmful. Therefore,
saving turns into misfortune. This is known as paradox of thrift.
The paradox of thrift can be
illustrated graphically as follows:
Above given diagram is showing
"paradox of thrift". In this diagram, income is along on OX-axis and
saving and investment along on OY-axis. SS and II curve are the original saving
and investment curves respectively. They intersect each other at point E and
give us the equilibrium level of income OY at which savings are equal to
investment. Now suppose savings in the community increase shifting the SS curve
upwards to S1S1 which intersects the old II curve at E1.
This lead to a decline in income from OY to OY1. The decrease in
income from OY to OY1, results in a reduction in the volume of
savings from YE to Y1E1. Thus, the community's efforts to
save more have actually led to a decrease in income as well as savings. If the
community attempts to further increase savings which shifts the saving curve to
S2S2, then the equilibrium level of income will decline
so much that savings as well as investment would become negative. This explains
the paradox that attempts to increase aggregate savings would actually lead to
a decrease in savings. Therefore, 'saving is vice not virtue'.
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