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The paradox of thrift is an economic theory that suggests when people save money instead of spending it during a recession, it can make the recession worse, even though the overall savings rate remains the same. This theory is used to promote consumer spending during economic uncertainty. Critics argue that the theory is not always harmful as demand can increase when prices fall, and savings can represent loanable funds.
The paradox of thrift is an economic theory posed by John Maynard Keynes, a well-known 20th century economist. According to Keynes, when people start saving money instead of spending it in response to growing worries about a recession, it can actually make the recession worse, while the overall saving rate stays the same. This argument is often used to promote consumer spending in times of economic uncertainty and has led numerous governments to spend heavily during recessions in an effort to keep these events from getting worse.
The rationale behind the paradox of thrift is this: when Person A puts money in the bank instead of spending it, that money doesn’t end up in the cash register of firm B. Business B, in turn, is forced to lay off workers because fewer people are spending in its establishment. These laid-off workers have no cash to spend, therefore making other businesses reel as they begin to experience a decline in customers, and over time, the recession grows deeper and deeper, with people grabbing onto as much cash as possible instead of spending it. .
When the paradox of thrift comes into effect, the overall savings rate in a society remains the same, because while the wealthier members of society may be able to put large amounts of money into savings, people in the lower classes have no savings. because they have no jobs. When saving is averaged across the population, the low and high saving rates at opposite ends of the class spectrum cancel each other out.
People refer to this theory as a “paradox” because it’s a case where seemingly beneficial behavior is actually harmful. While individuals do indeed benefit from choosing to save money instead of spending it, society as a whole suffers economic problems when large numbers of people start saving, according to the paradox of thrift. This theory is also believed to be true for consumers who pay off debt instead of spending money or putting it into savings.
Numerous criticisms have been leveled against the paradox of parsimony, a reminder that this principle in economics is a theory, not a stated fact. Some people have argued that when demand falls, prices fall and this again triggers an increase in demand, so the paradox of thrift is not as harmful as has been suggested because demand rarely falls below a certain level. Others have argued that the money in savings represents loanable funds, meaning that by putting money in the bank, someone can benefit their community by making funds available for people who need to borrow them.
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