Paradox of Thrift

The concept of paradox of thrift is a paradoxical because it contradicts with popular saying “A peni-saved is peni-earned”. This may be true for individual but not for the society. According to classical economist saving is a private virtue because every individual should save something for his difficult days. Saving is positive function of rate of interest and investment is negative function of rate of interest. Rate of interest is determined by the interaction between saving and investment. Therefore, according to classical economist saving is both private as well as social virtue.

                       

But Keynes rejected the idea of classical economist and he claimed that ‘saving is a vice not a virtue’. Saving is increasing function of current income. In other words, saving varies positively with current income. Since one man’s expenditure is other’s income. Increased saving means less consumption and hence less of effective demand which leads the reduction in income, output and employment in the economy. Hence, according to Keynes, “saving is a big social vice not a virtue”.

The paradox of thrift can be shown with the help of following diagram:

In the above figure E is the initial equilibrium where investment (II₁) intersects saving curve (SS₁). This equilibrium shows that income equilibrium is OY₁. At this level of income equilibrium saving and investment is Y₁E₁, when saving is the society increases. The saving curve shifts upward from S₁S₁ to S₂S_2. It leads to decrease in consumption, investment and income. As a result new equilibrium is formed i.e. E, which S₂S₂ intersects with investment curve II_1. This equilibrium level of income and equilibrium saving and investment are OY₂. It implies that saving in current period leads to decrease in both saving and income in future.