The paradox of thrift and household saving behavior effects on the economy

Paradox of Thrift: Discussion

The 'paradox of thrift' in basic terms observes "that attempts to increase saving, by reducing spending and aggregate demand, may lower output and national income so much that the actual ex-post savings end up being smaller than at the onset" (Berglund and Vernengo, 2006, p.149). I fully concur with the reasoning behind this theory. In most cases, people believe that saving is a virtue. Therefore, whenever they can, people will always try to put aside some cash "for a rainy day." However, it is important to note that when this is done en masse, the consequences for the entire economy could be dire. This is more so the case when there is a downturn in economic activity and as a result, people panic and increase their savings.

To begin with, when people/consumers increase their savings, they inevitably decrease their spending. In such a case, businesses face a sustained decrease in revenues. To remain relevant in the face of decreased revenues, affected businesses embrace various strategies including but not limited to expense/cost reduction measures such as layoffs. Businesses in such a case could also cut down on their investments. This is what those who agree with the 'paradox of thrift' argue could end up worsening a recession. According to Dransfield and Dransfield (2003), this particular paradox was proposed by J.M. Keynes -- a popular economist whose macroeconomic ideas continue to be relevant to date. Keynes was convinced that consumer spending was a good thing as it led to enhanced incomes. To him, what consumers spent trickled down as income to various workers employed by business entities and for this reason, reduced spending would deny business entities sufficient revenues to either hire more workers or sustain their relationship with existing workers. The subsequent layoffs and decreased investment into other business opportunities would in the end erode the ability of the people to save.

It should however be noted that the 'paradox of thrift' has in the past been disputed by those who do not necessarily have the same point-of-view as Keynes. It would be prudent to recognize their views. Some of those opposed to the paradox are of the opinion that increased savings enhance the lending ability of banks. With more money to lend inform of loans, banks gradually reduce their lending rates in a move that motivates more people and businesses to borrow. This ends up stimulating further lending and investment. According to Boyes and Melvin (2010), higher saving could be induced by enhanced demand for investment savings. As the authors further point out, "if increased saving is used to fund investment expenditures, the economy should grow over time to higher and higher levels of income" (Boyes and Melvin, 2010, p.221).