Paradox of thrift

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The paradox of thrift is a paradox of economics propounded by John Maynard Keynes. The paradox states that if everyone saves more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population. One can argue that if everyone saves, then there is a decrease in consumption which leads to a fall in aggregate demand and thus leads to a fall in economic growth.

The simplified form of the argument is that in equilibrium total income (and thus demand) must equal total output, and that total investment must equal total saving. Assuming that saving rises faster as a function of income than the relationship between investment and output, an increase in the marginal propensity to save, all other things being equal, will move the equilibrium point at which income equals output and investment equals income to lower values.

In this form it is a prisoner's dilemma as saving is beneficial to each individual but on a whole it can be harmful. This is a "paradox" because it runs contrary to common intuition. One who does not know about the paradox of thrift would fall into the fallacy of composition. This fallacy arises when one infers that something is true of an economy from the fact that it is true of an individual. Although exercising thrift might be good for an individual, by enabling that individual to save for a "rainy day", it might not be good for the economy as a whole.

This paradox can be explained by analyzing increased savings in an economy. If a population saves more money (that is that the marginal propensity to save increases across all income levels) then total revenues for companies will decline. This decrease in economic growth means fewer raises and perhaps downsizing. Eventually the population's total savings have remained the same or even declined because of lower incomes and a weaker economy. This paradox is based on the proposition, put forth in Keynesian economics, that many economic downturns are demand based.

Non-Keynesian economists criticize this theory on two grounds. First, if demand slackens and prices fall, the resulting lower price will stimulate demand, which tends to limit the decline in demand. Secondly, and perhaps more importantly, "savings" represent loanable funds; an increase in the supply of loanable funds tends to lower interest rates and stimulate borrowing, so a decline in consumable goods with a short time horizon is offset by an increase in production in sectors with longer time horizons. For example, the demand for personal electronics might decline, but the demand for such things as real estate would be stimulated by favorable borrowing conditions.