Paradox of thrift refers to a situation in which people tend to save more money, thereby leading to a fall in the savings of the economy as a whole. In other words, when everyone increases his/her saving-income proportion i.e. MPS (s), then, the aggregate demand will fall as consumption decreases. This will further lead to a decrease in employment and income level and finally this will reduce the total savings for the economy. This concept was suggested by Keynes wherein increased saving at individual levels will gradually lead to the slowdown of economy in terms of circular flow of income. Let us understand this statement with the help of the fig. 8.14.
In Fig. 8.14, initial saving curve is SS and investment curve is II. Economy attains equilibrium (Saving = Investment) at E and equilibrium level of income is OY. Now, suppose the society decides to become thrifty by reducing consumption expenditure and Increases saving by, say, AE. As a result, saving curve shifts upward to S1S1 intersecting Investment curve II at E1. Unplanned inventories will increase and firms will cut down production and employment and move to new equilibrium E1. The figure shows that in the end, planned saving has fallen from AY to E1Y1. Notice at new point of equilibrium E1, investment level and also realised saving remain the same (E1Y1) but level of income has fallen from OY to OY1. The decline in equilibrium level of income shows the paradox of thrift as the reverse process of multiplier has worked on reducing consumption expenditure. In fact Increased saving is virtually a withdrawal from circular flow of income.
