Saving and Investment: Paradox of Thrift (With Diagram)

Equilibrium national income occurs when planned saving equals planned investment. This saving-investment statement of the equilibrium condition once became a bone of contention between the classicists and Keynes.

The debate centered around the virtue or vice of saving or consumption. The controversy between them stemmed from the determinant of saving.

Classicists believed that saving depends on the rate or interest, i.e., S = f(r). Savings, in the classical system, are interest-elastic.

Further, clas­sicists assumed Say’s Law. The law states that “Supply creates its own demand”. The implication of the Say’s Law is that what the society saves is automatically invested. Saving is exactly matched by investment—there cannot be any discrepancy between saving and investment.

As savers and investors are assumed to be the same group of persons, actual saving and actual in­vestment”, desired saving and desired invest­ment are all equal. If it is so, saving is a virtue to the nation. Greater the saving, greater the pros­perity of a nation. Instead of saving, if people plan to consume more it will bring disaster.

But Keynes challenged this classical con­tention. Keynes argued that saving depends on income, rather than the rate of interest as suggested by the classical economists. Saving is directly related to national income. Above all, Keynes demolished Say’s Law. To him, savings do not cause investment since savers and investors are two different persons in the community. Keynes went on saying further that if a nation decides to save more the na­tion will be struck by disaster. Increase in in­dividual saving is not equivalent to an increase in saving of the community. In fact, what is true for an individual is not necessarily true for the society as a whole.

What will happen if an individual decides to save more and consume less? It is to be re­membered here that we live in an interde­pendent society where reduction of consump­tion (or increase in saving) of one individual is tantamount to a reduction in income of an­other member of the society. So, saving must decline since saving depends on income. So, we can conclude that if the society plans to save more, actual saving, national income, level of employment, etc., will decline. This is known as ‘paradox of thrift’. That is why Keynes said saving may be a virtue to an in­dividual but community saving lowers down society’s welfare.

This is demonstrated in Fig. 3.13 where S₁S₁ is the initial saving curve. l_p is the planned induced investment line. Thus, investment is no longer assumed here as an autonomous one. It is dependent on income. S₁S₁ and I_p curves intersect each other at point E₁. Corre­sponding to this point, equilibrium income thus determined is E₁ If people decide to save more rather than to consume, the saving func­tion would shift to S₂S₂.

So, the planned sav­ing now rises from E₁Y₁ to AY₁ Since aggre­gate demand or aggregate expenditure falls short of aggregate income, it will result in a piling up of unsold goods. Income will conse­quently fall. Investment will tend to decline until planned saving is equal to planned in­vestment (i.e., point E₂). Level of income is now OY₂ (< OY^. The actual volume of sav­ing will now fall from E₂Y₂ to E₂Y₂, as a result of increased desire to save. This is the para­dox of thrift.

Thus, the paradox of thrift contradicts the general view that “a penny saved is a penny earned”. If so, then how does such paradox of thrift hold always? Answer is—no. Look at Fig. 3.13. If planned induced investment shifts up then equilibrium national income will in­crease. Suppose I_p line shifts up and cuts S₂S₂ line to the right of point A, then a larger in­come will be available. Thus, thriftiness is not unwise or unwelcome proposition. However, this result is dependent on many factors.