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 saving. It must be between 0 and 1, with 1 representing all additional income going toward consumption, and 0 representing no additional income going toward consumption.
Autonomous consumption is the level of consumption expenditure that must occur given basic necessities: food, shelter, and utilities. Thus, a change in autonomous consumption is exogenous change which isn’t tied to income levels (basically saying that the amount of food you need to consume to survive doesn’t change depending on income).
Putting that together, change in national output reflects how much additional income people will save and changes in autonomous consumption. Because Δc₀ < 0 means Δc₀ is negative, then (1/(1-c₁)) being positive will incur a negative change in output, since a positive multiplied by a negative is a negative. Let’s take two examples:
MPC = 10%
(1/(1-c₁)) = 1/(1 - .1)) = 1/0.9 = 1.11
ΔY* = 1.11(Δc₀ < 0)
MPC = 50%
(1/(1-c₁)) = 1/(1–0.5) = 1/0.5 = 2
ΔY* = 2(Δc₀ < 0)
Let’s say that Δc₀ is a constant -1:
MPC = 10%: ΔY* = -1.11
MPC = 50%: ΔY* = -2
Thus, we can see that a higher marginal propensity to consume amplifies the negative impact on growth when autonomous consumption is negative. This is the savings paradox.
Thus, we’ve explored both the conceptual backing for why saving more can be harmful to growth, and the mathematical backing to the saving paradox.
Hope you got what you were looking for! Check out my other articles on economics here (useful for studying, or just learning).
