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Children are taught to save for a rainy day, as it is considered the preparation for a safer, possibly better, future. However, one of John Maynard Keynes' early theory suggested that the attempt by the economy as a whole to increase aggregate of saving will not only fail, but may lower aggregate output, income and employment. It is later called the Paradox of saving (or Paradox of thrift).
The main reason is because increased saving means decreased consumption, at a given level of income; and the stimulating effect of investment and other spending will be reduced by the smaller marginal propensity to consume.
For example, suppose that an economy has the following consumption function
C= c0+ c1YD=$100+0.8YD
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The multiplier therefore is1/(1-0.8)=5
And the autonomous investment (I) is equal to $00 billion, the equilibrium level of income (and output) is YE=[1/(1-c1)] (c0+I)=5(100+00)=$000
Aggregate consumptionC=100+0.8¡Á000=$1700
Aggregate saving S=YD-C=YE-C=000-1700=$00=I
Therefore aggregate saving equals to aggregate investment
Further assume, it is suggested that we should save more in order to grow, and people follow by increasing their propensity to save from (1-0.8) to 0.5. Now C=100+0.75YD
The new multiplier is1/0.5=4
Thus new aggregate equilibrium level of income and output is
Y'E=[1/(1-c1)] (c0+I)=4(100+00)=$1600
The new aggregate consumption
C'=100+0.75¡Á1600=$100
New aggregate savingS'=1600-100=$00
As can be seen, saving still stayed at the same level ($00 billion) as before, equaled to investment, whereas national income level (and output) was lowered by $400 billion in figure.
This model can be illustrated with a simple graph.
Suppose there is an exogenous increase in aggregate saving (e.g. because of the fear of losing job), S1 shifts upwards.
lBefore Y1=equilibrium and I=S=A
lAfter shift S=B£¾A=I, imply supply exceeds demand. Y=new equilibrium, as income decreases, saving decreases from B to A and I=S again, and Y£¼Y1!!
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Therefore the paradox suggests that saving is harmful to the economy, as, while thriftiness is a desirable goal for an individual, for the nation as a whole it's a disaster. If we all decide to save ¡ª that is, not to spend ¡ª the economy, and national income, will fall, making everyone poorer. 1
This conclusion seems meaningful, especially in the short run, as people are not confident with the economy or their lives (for whatever reason), saving can be increased as soon as they want to, causing sharp fall in demand in general, possibly followed by a recession.
However, it's clear that this model is very simplified, in terms of having investment at a fixed level and no government playing any active role. If taking into account of these exogenous factors, the turnout could be very different. E.g.. the investment level is not (and I personally think it is certainly not) independent and government could take steps in directing private saving into investment
First, a large proportion of private saving would be in commercial banks, and it could be invested through deposits (providing leaving enough cash for daily transactions). Therefore saving is transferred into investment.
Second, the existence of the government will be having an effect. Government investment is counted as well as private investment and is under control. Also the change in monetary policy, more precisely the interest rate will discourage saving (less return) and encourage investment (less costs). Thus bring S and I back to equilibrium without having to lower Y.
The previous graph is revised if an increase in planned saving will lead to an exogenous increase in planned investment. Both the investment and the saving functions will shift vertically upward.
lBefore Y1=equilibrium and I=S=A
lAfter change Y remains at Y1. Saving increases from point A to point B.
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As a result, the income may not decrease and the realised saving will increase.
However, it could be argued that aggregate saving involves firms as well, so the opportunities for banks to lend money may still be low since everyone, especially firms and businesses, are (assumed in the model) to be saving as well.
Also, there is a possibility that (the) potential savings are so high compared with investment opportunities that the government is impotent to bring the two in line even at a near-zero interest rate. This happened during the 10's, when the rate on Treasury bills was less than one-tenth of 1 percent in America; it's arguable for Japan's current position (with almost 0% interest rate) too.
To conclude, the paradox of saving suggests, Insurance against disaster will ultimately destroy the wealth of the family. Although it may sound paradoxical For what we need now is not to button up our waistcoats tight, but ... to buy things4, it is true in a way since even the government may not resolve the negative impact of increasing aggregate saving, i.e. it can not be offset easily in a short run, short enough for the economy not slipping into a recession. This could be one of the reasons by current Prime Minister urged people not to Talk ourselves into recession, since saving is largely determined by expectation as well as interest rate.
Still, saving is almost an instinctive act of men, if we don't provide for the future, we don't survive the future. Without saving, the long-run economic growth would have no base at all. Thus saving is unarguably beneficial in the long term. It is how long this potential growth of prosperity will finally come that matters, and we could almost hear Keynes' voice, In the long run we are all dead. Still, even if the long run is prolonged because of the economy's lack of strength to get out of recession, or government impotency, saving is needed.
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