Paradox of Thrift
Suppose people decide to become more thrifty, that is, they decide to save more at each level of income. One might expect that this would increase the total amount of savings, but the simple Keynesian multiplier model predicts a paradox of thrift, that total savings will remain the same and income will decline.
If people become more thrifty, they consume less at each level of expected income. Increased thriftiness can be illustrated on a graph as a shift downward of the consumption function or a shift upward of the savings function. If you draw in these shifted lines, you will see that equilibrium income will fall. But since in equilibrium savings plus taxes must equal investment plus government spending, and because by assumption investment, taxes, and government spending are fixed, in equilibrium savings cannot change. In fact, if we allowed investment to increase a bit with income (but not by too much, or the model has an unstable equilibrium), then the investment line would slope upwards a bit. At the new equilibrium caused by increased thriftiness, savings would actually be less.
Another way to illustrate the logic of the paradox of thrift uses the analogy of the leaky bucket. Consider what will happen if the savings hole in the bucket is made a little larger, which corresponds to people becoming more thrifty. Initially there will be a larger flow of water out. But this cannot continue indefinitely. Equilibrium exists when the inflow equals the outflow, and the inflow has not changed. This means that the water level must drop so that the pressure forcing water out the bottom will be reduced. Less pressure means less outflow, and at some lower level of water equilibrium will be reestablished.
With the paradox of thrift, the multiplier model makes an important prediction of an unintended consequence. Prior to Keynes, most economists had argued that savings were helpful to the economy because saving spurred investment and larger amounts of capital increased the productive capacity of the economy. Hence, a slower rate of savings would reduce the growth rate of the economy. In contrast, the paradox of thrift implied that more savings could harm the economy. Many early followers of Keynes, and probably Keynes himself, were "secular stagnationists" who believed that a lack of spending was likely to be a chronic problem in an industrialized economy, and therefore they thought that measures should be taken to reduce savings. Since the rich did most of the saving, an obvious solution was to tax the rich to reduce their incomes and thus their savings. Those who had wanted to tax the rich with the goal of equalizing incomes had, prior to Keynes, been confronted with the argument that such a move would have harmful effects on growth. It is not surprising that they were often eager to embrace a theory that implied that equalizing incomes had only good side effects. (The tendency for macroeconomic theories to be popular or unpopular as much for their political implications as for empirical support has existed for all theories, not just this multiplier model.)
Another implication of the model was that the government should be more active in the economy.
Copyright Robert Schenk