Sunday, January 13, 2013

Paradox of Thrift

The paradox of thrift is defined by as:

The notion that an increase in saving, which is generally good advice for an individual during bad economic times, can actually worsen the macroeconomy causing a reduction in aggregate income, production, and paradoxically a decrease in saving. The paradox of thrift is an example of the fallacy of composition stating that what is true for the part is not necessarily true for the whole.
The paradox of thrift is counter intuitive concept that savings is good because there's money for the financial sector to loan out.  But as more income is saved, there's less spending and incomes fall.  Algebraically, income, Y, is equal to consumption, C, plus, Investment, I, plus Government spending, G.  That is, Y = C + I + G.  Subtracting C + G from the right side of the equation equals Y-C-G = I.  Reducing the left side, equals S = I.  If C decreases, savings increases and so should investment.  But, consumption is 70% of GDP and is a major component.  Investment is only 14% of GDP.  So the increase in investment is more than offset by the decrease in consumption and income falls.  The paradox is explained that for the individual savings is good, but on the whole the economy suffers.

During a recession, people fear the future and increase their savings.  But was this indeed the behavior seen in the United States since 2007?  This Federal Reserve graph shows that people are saving less.

The paradox of thrift also shows that macroeconomics is a rough predictor of behavior.  Since people are saving less, shouldn't spending increase?  Clearly, this model is impoverished.

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