The paradox of thrift refers to a situation in which people tend to save more money, resulting in a drop in the economy's overall savings. To put it another way, if everyone increases their saving income proportion, i.e. MPS(s), aggregate demand will fall as consumption falls. This will result in a reduction in employment and income, as well as a reduction in total savings for the economy. John Maynard Keynes, a British economist, proposed and popularized this concept. He believes that increasing individual saving will contribute to a progressive slowing of the economy in terms of the circular flow of income. Some have compared it to the Prisoner's Dilemma in that saving is beneficial to the individual but harmful to the entire nation. With the help of the diagram below, we can better grasp this statement:
The beginning saving curve is SS, and the investment curve is II in Fig. 8.14. At E, the economy reaches equilibrium (savings Equals investment), and income is at OY. Assume that the society decides to become more frugal by cutting consumption and increasing savings by, say, AE. As a result, the saving curve swings upward, intersecting Investment curve II at E1 at S1S1.
Unplanned inventories will rise, companies will reduce production and employment, and move to new equilibrium 1 will be disrupted. The chart depicts how, in the end, intended saving fell from AY to E1Y1. Notice that at the new point of equilibrium E1, investment levels and realised savings remain unchanged (E1Y1), but income levels have declined from OY to OY1. The paradox of thrift can be seen in the decline in equilibrium level of income, as the reverse process of multiplier has worked to reduce consumption expenditure. In reality, increased saving is essentially a withdrawal from the revenue cycle.