The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.
Understanding the paradox of thrift
When consumers choose to save their money over spending it in a recession, this harms the businesses that sell goods and services. The business experiences fewer sales and a decrease in productivity and cannot sustain as many employees as a result. When some of these employees lose their jobs, they have less disposable income to spend and the recession may deepen.
This disconnect between individual and group rationality is the basis of the paradox of thrift. Consumers reduce their consumption and attempt to increase their savings during a recession because it makes sense for them to do so. But it does not make sense for the broader economy since consumer savings are removed from the circular flow of income. This means they cannot contribute to an increase in consumption and demand.
The paradox of thrift and the circular flow model
The paradox of thrift can be explained by the circular flow model which demonstrates how money moves through society. In general terms, money flows from producers to workers as wages and then from workers to producers as payment for a product or service.
The circular flow model starts with the household sector and consumer spending. To boost this spending, Keynes said banks needed to lower interest rates to make saving money in a bank account less attractive. If this strategy was ineffective, the government could use deficit spending to take on debt and use its power to stimulate demand in the economy.
Criticisms of the paradox of thrift
The paradox of thrift has been criticized by neo-classical economists.
These economists believe that a consumer saving their money sends a signal to the market that they do not want to consume any goods or services at current prices. To counteract this scenario, producers can lower their prices or change the goods and services being produced. In essence, the lack of consumption forces the market to optimize and does not, as Keynes suggested, reduce future output.
To a lesser extent, the paradox of thrift also ignores the ability of a bank to lend out consumer savings to other consumers or companies to stimulate demand. Neoclassical theorists also suggest that consumer savings are essential to growth and technological innovation, with a capital threshold reached before such innovation can raise the total output of an economy.
Lastly, the paradox of thrift ignores Say’s Law of Markets, a classical economic theory that states that goods must be produced before they can be exchanged. In other words, the source of demand in an economy is due to the production and sale of goods for money and not from money (spending) itself.
- The paradox of thrift is an economic theory arguing that personal savings are a net drag on the economy during a recession.
- The paradox of thrift is based on a disconnect between individual and group rationality. Consumers reduce their consumption and attempt to increase their savings during a recession, but this removes money from the circular flow of income and exacerbates the problem in the broader economy.
- The paradox of thrift has attracted criticism from neo-classical economists who suggest that markets will self-correct when faced with low consumer demand. The paradox of thrift also ignores the ability of banks to lend out consumer savings to stimulate demand in the economy.
Read Next: Circular Flow Model.
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