What happens if we as a society try to save more? Classical analysis suggests that saving promotes investment and growth, but a potential "paradox of thrift" may pose a problem.
Keynesian theory suggests that attempts to save more may cause income to fall so much that actual saving shrinks, a problem known as the paradox of thrift.
Most of us consider thrift a virtue. Ben Franklin's adage, "A penny saved is a penny earned," haunts many of our psyches, and we think we might be better off if we saved more. The term paradox correctly reflects, however, the belief that Ben's adage may be inappropriate for the overall economy at times. Basic Keynesian analysis indicates that if we all try to save more, we may all wind up worse off and actually save less.
Showing how the desire to save more may cause actual saving to fall requires a slight, but temporary, change in the assumptions used to build a simple Keynesian model. We have assumed that investment is autonomous, or unaffected by income. A more realistic assumption is that as income rises, firms become more optimistic about the profit prospects from new investment. Hence we will assume that investment rises as income rises.
Consumption, however, falls when households try to save more. Firms counter declining sales and swelling inventories by cutting production, employment, and investment. Thus, the paradox of thrift suggests that increased desires to save may shrink actual saving and investment, with income and consumption also falling, leaving people with lower standards of living. This Keynesian line of reasoning certainly raises questions for those of us who think that more saving is always good for the economy. Unfortunately, increased saving may be a typical household response at the worst possible time—when an economy begins to slip into a recession. If families fear that breadwinners will lose their jobs, they may begin saving a little more each payday, trying to build nest eggs to cover expenses should income tumble. If growing numbers of households adopt this strategy, momentum for a recession will build.
The paradox of saving is probably irrelevant in an economy operating close to its capacity. Classical theory suggests that increased desires to save drive down interest rates, which stimulates investment and economic growth. The economic climate determines whether saving is more likely to depress income—a Keynesian possibility—or if greater willingness to save facilitates economic growth, as classical reasoning implies.