Paradox of Thrift

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Thrift may be a virtue for the individual, but could damage the economy as a whole. This is the paradox of thrift. The more people saved, the more they reduced effective demand, thus further slowing the economy, said economist John Maynard Keynes, writing in the midst of the Great Depression in the 1930s. This was one reason, he pointed out, that a recession can become self-reinforcing.

Contents

Why should I be aware of this?

This cascading effect would result in a slowdown in the economy, and would mean less income for everyone, and ultimately reducethe absolute amount of savings, even if people increase the proportion of their income they put aside. As unemployment grew, investment would fall, whatever the level of savings.

This collective paradox that what was good for the individual would weaken the economy can only be overcome by the government. With this theory as the base , governments across the lien are pouring money back into the economy. Central banks across the world started to intervene by cutting interest rates, injecting liquidity, and recapitalizing weakening banks and financial institutions. These interventions have been unparalleled in the history of the global financial system.

All about Paradox of Thrift

John Maynard Keynes in the 1930s revised the view of the classical school of economists that what was saved was later invested by asserting that thrift was virtuous only up to a point. If an individual increases the proportion of his income, this resultant reduction in expenditure would lead to reduced demand in the economy. His thrift is justified only up to the point where business would borrow his money to invest.

Prior to Keynes, most economists held the theory that savings were helpful to the economy because saving spurred investment and larger amounts of capital increased the productive capacity of the economy. A slower rate of savings would reduce the growth rate of the economy.

In contrast, the paradox of thrift implied that more savings could harm the economy. Many early followers of Keynes believed that a lack of spending would create problems within the economy which would become chronic. They, therefore, propagated that measures should be taken to reduce savings.

Today's economy and Paradox of Thrift

The economy is a mess. Consumers facing falling home prices, debt, tightening credit and rising food prices. The gains realized during the dot-com and housing booms have evaporated. Credit markets remain frozen shut. Consumer spending has plummeted. New home sales and orders for durable goods are bottoming out.

Nothing is more important right now than consumer morale. If consumers quit shopping, then the economy will go into a deflationary cycle that will be difficult to fix.

Unlearn

One reason Keynesian explanations of the economy fell out of favour in the last few decades was the rise of a new economic theory - rational expectations.

This argued that people were aware that any government borrowing would have to be paid back later. As a result they adjust their expectations accordingly, and do not spend as much as predicted. [1]

References:

  • The paradox of thrift
  • Economy Professor

Source

  1. BBC Channel News