What is the Savings Paradox in Economics? (why saving more isn’t always better)
In previous models we’ve explored, including the Solow Growth model and the relationship between capital and output, we’ve noted that output (GDP) is driven by capital per worker, which is in turn driven by investment, and investment is a function of savings.
Thus, we arrive at the interesting paradox of saving in macroeconomics (sometimes called the paradox of thrift): as consumers attempt to save more, the result can be both a decline in output and unchanged or even reduced savings.
The core reason for this is that the missing effect of capital accumulation and innovation. It’s the idea that if everyone took their money and shoved it under their mattress, then the economy would be worse off, with stagnant or negative growth as spending slows and businesses have no reason to invest in new capital and innovation.
To derive this mathematically, note the following equation:
ΔY* = (1/(1-c₁))Δc₀ < 0
Where, ΔY* is the change in output, c₁ is the marginal propensity to consume (MPC), and Δc₀ is the change in autonomous consumption independent of income.
The marginal propensity to consume is the fraction of additional income that households choose to spend on consumption as opposed to…
