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Case Study: the Paradox of Thrift Page 1 of 1 Aggregate Expenditures Model Components of Aggregate Expenditure Case Study: The Paradox of Thrift Page 1 of 1 I'm here at the bank making a deposit in my savings account and feeling very virtuous, because our culture regards saving as a virtue. However, what makes sense for one person, that is what’s good for me to do may be bad if everyone tries to do it at once. This was an insight of John Maynard Keynes’. He says, “Think about it. When you're saving, you're not spending. And if everyone reduces their spending at once, they may create a recession.” This is what he called the paradox of thrift. That is, when I come to the bank and put my money in the vault, I am, at that same moment, making a decision not to spend it. And when I don’t spend, I am reducing aggregate demand. And when I reduce aggregate demand, I am reducing income for someone else down the line. That is, my decision to put money in the bank is a decision not to buy a compact disc, which means that the record storeowner won’t be buying ice cream, which means that the ice cream vendor won’t be buying a T-shirt. And the multiplier effect works in reverse, causing the economy to contract. Think about this: savings has two components; there’s autonomous savings, the amount that you're going to save regardless of what your income is, and then there’s that amount of savings that depends on your income. For each additional dollar in income that you get, you're going to be saving a fraction of it, called the marginal propensity to save. So here’s what happens; savings is a leakage out of the flow of goods and services. If everyone increases their autonomous savings, what they're doing is reducing demand, which means that businesses are going to cut back production and income is going to be falling. Eventually, what happens is that savings has to be equal to investment. That’s our condition for macroeconomic equilibrium. So if investment is autonomous, that means, if it’s a fixed amount, then what has to happen is the amount by which we have increased autonomous savings has to be the amount by which the economy reduces savings based on income. Income is going to shrink until savings falls to be exactly equal to the level that it was before everyone tried to save more. This means that since savings equals income, our efforts to try to increase our aggregate savings are fruitless and the only thing that’s accomplished is a reduction in gross domestic product. People stop spending, businesses stop creating goods and services, and the economy shrinks. This may be what happened during the Great Depression. People were fearful for the future and tried to save more money. But, when they did, they didn’t spend and therefore stores closed down, and people didn’t have jobs and income fell further and the economy contracted. The same thing may have happened in Japan. The Japanese have a reputation for saving a lot. This was great during the 50’s and 60’s when there was a lot of productive capital investment to be undertaken. However, in the 80’s and 90’s, it worked against Japan, because their economy was in a recession and everyone was trying to save. And when the foreign sectors stopped keeping the economy afloat, the Japanese economy contracted further. They were saving too much and it wasn’t until the government started spending for the economy that the economy began to grow again. My brother and I have this argument; he says that I should spend more and do my part to create jobs and help the economy grow. I believe, however, that I am doing my part for the economy whenever I put money in the bank. That’s because there’s a component to the story of the paradox of thrift that I think is oversimplified, and that’s the idea that investment is autonomous. In fact, investment spending depends on the interest rate. And when the interest rate is lower, businesses are likely to come to the bank, borrow more money and build more factories and install more equipment. So what happens when I bring my money into the bank is that I increase the supply of loanable funds, pushing down the interest rate and encouraging businesses to borrow more. Once you allow the interest rate to vary and businesses to respond to lower interest rates, than savings can equal investment at a higher level. That is more savings means more investment in equilibrium. And my savings actually doesn’t deter the economy from growth. In fact, I’m encouraging businesses to install capital stock that’s going to help the economy grow faster in the long run. So the paradox of thrift depends on a very simple view of the economy, one in which investment spending is autonomous. But if you introduce the interest rate and allow increased savings to push the interest rate down, then you can reason your way out of the paradox. Keynes was smart to come up with this idea, the idea that savings is the opposite of spending, therefore the more you save, the less you spend, and you may cause the economy to shrink. On the other hand, once you reintroduce the variable interest rate and see how savings is linked to the interest rate, you can see that putting your money in the bank is usually a very good idea, because it makes credit easier to get for businesses and, in the long run, increases our standard of living. .
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