Savings Paradox Revealed: Exploring the Intricacies of the Marginal Propensity to Save

The Paradox of Thrift suggests that when individuals in an economy collectively increase the proportion of their income that they save (i.e., when the marginal propensity to save, or MPS, increases), the total value of savings in the economy may not necessarily increase; it can either decline or remain unchanged(Refer Figure).

Consequences of Marginal Propensity to Save in Aggregate Demand Models

• This paradox may seem counterintuitive at first glance, but it can be understood as a consequence of the economic model we’ve learned.
• An exogenous shift in people’s expenditure pattern results in an increase in the marginal propensity to save (MPS) or a decrease in the marginal propensity to consume (MPC), leading to a decrease in aggregate consumption spending and aggregate demand.
• The Decrease in Aggregate Demand and Its Impact:
  • It causes producers to reduce production to restore market equilibrium. 
  • This reduction in production leads to a decrease in income and consumption expenditure.
• Iterative Adjustment in Production and Income: 
  • The Process of Adjustment continues with each round of production and 
  • Income decreases being proportional to the new MPC value.

Paradox of Thrift – Downward Swing of AD Line

• Convergence to New Equilibrium: The process is convergent, meaning that it eventually reaches a new equilibrium.
• Geometric Series Analysis: 
  • The total decrease in the value of output and aggregate demand due to the change in MPC is calculated as a geometric series, resulting in a significant reduction in both values.
  • Despite changes in MPC, the total value of savings in the economy remains unchanged.
  • Changes in parameters A (autonomous spending) and c (MPC) affect the position and slope of the aggregate demand (AD) line in the AD-AS (Aggregate Demand-Aggregate Supply) model.
  • An increase in Marginal Propensity to Save or a decrease in MPC results in a downward shift of the AD line, indicating a reduction in equilibrium output and aggregate demand.
• Overall, this analysis demonstrates the impact of changes in the MPC on the equilibrium output and aggregate demand in an economy and highlights the role of MPC in influencing economic stability.

Equilibrium Output and Employment Dynamics – Discovering the Impact of Deficient and Excess Demand in the Economy

• The equilibrium level of output in the economy determines the level of employment, given the quantities of other factors of production.
  • This can be understood by thinking of a production function at the aggregate level, where output depends on the combination of various inputs.
• Full employment of resources: It occurs when all factors of production are fully utilized in the production process.
  • Equilibrium doesn’t necessarily mean full employment of resources. 
  • The equilibrium level of output may be either higher or lower than the level of output at full employment.
• Deficient Demand:
  • If the equilibrium level of output is lower than the full employment level, it suggests that the demand in the economy is insufficient to employ all available factors of production. This situation is known as deficient demand.
  • It can lead to a long-term decline in prices as businesses reduce production due to weak demand.
• Excess Demand: 
  • If the equilibrium level of output is higher than the full employment level, it indicates that demand is greater than what can be produced at the full employment level. 
  • This situation is called excess demand and can result in long-term price increases as businesses struggle to meet the heightened demand.