Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Paradox of Thrift

What it is:

The paradox of thrift is an economic theory that states that the more people save, the less they spend and thus the less they stimulate the economy.

How it works (Example):

Developed by economist John Maynard Keynes, the paradox of thrift works this way: Assume everybody receives $1,000 of income. They save 50% ($500) and spend the rest ($500). This means everybody is spending $500, which supports demand for products, which in turn creates jobs, encourages entrepreneurship, and generates tax revenue for the government.

Now let's assume that everybody decides they need to save more for retirement. They start saving $750 of their $1,000 and spending only $250. Suddenly, there is a drop in the demand for goods and services. Businesses can't make a profit, and so they lay off workers, which raises unemployment and lowers the tax revenue to the government. The unemployed people, who now are out their income, stop spending altogether, which worsens the problem even more. The whole thing continues on a downward spiral.

Why it Matters:

Saving is a good thing, but as Keynes theorized, too much of it can harm the economy. Some level of spending is necessary to maintain a healthy economy, ensure that people have jobs, and continue providing tax revenue to the government.

Some critics of the paradox of thrift remind us that savings is often investinginvesting in companies that use the money to build factories, expand operations and hire more employees. Accordingly, savings doesn't necessarily halt the economy.