Paradox of Thrift – Definition & Explanation

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Paradox Of Thrift Definition

The paradox of thrift,  also known as the “paradox of savings”, is an economic theory stating that individual savings can hurt a nation’s economic productivity thus causing detriment to individuals within that nation.

A Little More on What is the Paradox Of Thrift

The paradox of thrift postulated by the British Keynesian economist, John Maynard Keynes. His theory was based upon Keynesian economic theory that productivity is driven by aggregate demand.

Pursuant to this theory, economic productivity is based upon aggregate demand by consumers. When consumers save (rather than spend), it harms the businesses that served the needs and wants of consumers.

When businesses have fewer sales, total productivity is lost. Thus, these businesses are unable to employ as many employees. The employees make up the consumer base. When employees begin to lose their jobs, they have less disposable income to spend. Thus, a cycle forms that results in lower overall productivity and worse economic conditions for the individual.

Even More Explanation of the Paradox Of Thrift

This economic theory is considered a paradox, as overall savings can be reduced due to the efforts of individuals to maximize savings.

This argument starts with the assumption that total income must equal total output in equilibrium. Keynes claimed that the level of production and jobs did not depend on production capacity but on the decisions of people in society to spend and invest their money.

He also argued that economic growth is driven by consumption or spending. Although reducing consumption during difficult times makes sense for individuals and families, this is the wrong approach for the bigger economy.

Some economists disagree critique the paradox of thrift for the following reasons:

  • If demand falls, then prices fall. The subsequent lower prices increase demand and can require increased production. The principle that increased supply increases demand is known as Say’s law.
  • Saving places more funds in banks. In turn, saving leads to increased bank lending. This increased lending provides capital for increased spending by businesses.
  • The paradox of thrift assumes a closed economy. It does not account for stable demand created by outside economies (such as sales in other countries).

Examples of Paradox of Thrift

Suppose everyone gets a salary of $1,000, saves 50% and spends the other $500, which increases product demand, creates jobs, encourages entrepreneurship, and generates tax revenue for the government.

Let us now assume that everyone is preparing for future retirement and decides to save more. They begin to save $750 and just $250 is spent. The demand for goods and services is abruptly decreasing.

Businesses are unable to make a profit, and so they lay off workers, which increases unemployment and reduces government tax revenue. The unemployed, who now lack wages, have stopped spending entirely. This aggravates the problem, even more, leading to a downward economic spiral.

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