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Journal 5: The Paradox of Thrift
October 2, 2011, 5:23 pm
Filed under: Weekly Posts | Tags: , , ,

I enrolled in Macroeconomics this semester in order to have a better understanding of how the economy works. Everything was going smoothly until one day, Professor Orlando Sotomayor said something in class that really caught me off guard. He began to talk about “the paradox of thrift”, which is a Keynesian theory that states that if all the consumers turn into saving their income at the same time, the economy would collapse instantly. In order to understand what this paradox states, I’ll give a small background in Macroeconomics.

Macroeconomics is the branch of economics that studies the structure of the economy. Unlike Microeconomics, which focuses on individuals – household, investment and government sectors – and their economic behaviors; Macroeconomics deals with the economy as a whole. Therefore, unlike Microeconomics, the decisions of one group, for example the investment sector, will affect the aggregate supply and demand of the whole economy, unlike Microeconomics, where the decision will only affect that specific sector’s supply and demand.

That being said, the most important figure in Macroeconomics is English economist John Maynard Keynes. Keynes became relevant during the Great Depression of the 30’s. Classical economists of that time thought that, in order to solve the Depression, which is a very aggravated recession (like the one we’re experiencing in Puerto Rico); no policy should be implemented: they believed the economy solved its own problems. And they were indeed right: the economy indeed solves most of its own problems; however, the economy will do this by balancing the Aggregate Supply and Demand until equilibrium between the two is accomplished. This means that the economy will produce as much as the society is willing to spend, or in other terms, it will produce exactly what consumers wish to buy. The problem with this belief is that the equilibrium between consumption and production isn’t necessarily the point in which every worker has a job, the point were Full Employment is accomplished. Therefore, politics have to be implemented in order to “force” the economy out of equilibrium to a point where it produces exactly the jobs that are needed. At this point, the economy soars.

In order to push equilibrium to the point of Full Employment, consumers, investors and governments have to spend more money. This is contrary to what most people believe should be done in this situation. Take a common household for example: if dad doesn’t have a job, he will most likely save as much money as he can in order to support his family later on. This type of thinking is incorrect. I’ll explain why with this graph:

In the graph, the y-axis represents the Price Level and the x-axis, Real Domestic Output, in other words production. The intersection of the black curve, which represents the Aggregate Demand or AD; and the other black curve, which points upwards, the Aggregate Supply, AS; its called the equilibrium point (RDO FE1, PL1) or the point in which the Real Domestic Output determines the Price Level. However, Full Employment is not achieved until FE2, and that equilibrium gives FE1. In order to achieve this point, the AS is moved towards the right, AS’, which means that the Aggregate Supply is maximized. This displacement creates a second equilibrium point (RDO’, PL’) which is the new production level of the economy (a higher level of production) and also the new level of prices (a lower level of prices). However this new point does not satisfy Full Employment either, which means that the AD has to be “pushed” up to AD’ (not shown in the graph) until it reaches (RDO FE2, PL1) which is a new level of production (a higher level) with the same level of prices the economy had at RDO FE1. In conclusion, in order to achieve Full Employment, the production of the economy has to expand while the level of prices remains constant. The only way of achieving this is moving AD towards the right, to AD’ (because AS was already moved to AS’), and this can only be done by policies implemented by the government; the economy alone can’t solve this issue because its nature is to go back to equilibrium (RDO’, PL’) where Full Employment can’t be achieved. The policies the government can assign to move AD to AD’ are limited: either lower the taxes so more consumers have available money to spend; or raise the spending of the government, which causes a general increase in production. To explain the Paradox of Thrift and for simplicity, I’ll assume this government reduced taxes to consumers.

If the government were to reduce taxes, more money would be available to consumers and if consumers have more money, they will save more money (if you won the lottery, would you spend all the money or would you save part of it?). This tendency to save part of the income is called a Marginal Propensity. The Paradox of Thrift is the extreme case in which this tendency would create a general attraction towards saving the newly increased income. If all the consumers of the economy saved most of their additional income, the new Aggregate Demand, AD’, would go back to the left (will be reduced) to the original one, AD, which will in turn reduce production from RDO FE2 (Full Employment Point) to RDO (point where Full Employment is not accomplished). This will create massive layoffs, which in turn, will make consumers save even more money, which will drop the production even more, worsening the economic situation. That being said, in order to maintain the economy in a full employment level – or “push” it to that point – consumption has to be increased (or stimulated by the government) whenever possible. In other words, using the model above, the government needs to force AD to the highest level possible in order to achieve Full Employment.

If you asked Keynes what he would do to make the economy soar, he would tell you something like this: “Spend as much money as possible. Spend on anything. Pay people to make holes in the earth one day and then pay other people to fill them the day after.”

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1 Comment so far
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Great topic. I never saw economy from this point of viewed. It was really nice for you to explain the terms like microeconomics and macroeconomics. Also the graph was a good resource. The best of all is that now I have an excused to spend money, in order to improve the economy.

Comment by kalacan




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