The classical economists considered saving to be a great virtue. They encouraged hard-work, maximum earning and minimum spending on consumption. They advised people to accumulate for future by maximizing earning and minimizing expenditure on consumption. Thinking aggregate savings as simply and aggregation of savings by individual members of the Community, they come to the conclusion that thriftiness improves the future of society. They also recognized that domestic saving was the major source of capital formation which is very necessary for economic progress.
However, Keynes pointed out that when we consider the community as a whole, we can no longer assume that when community reduces its consumption, its income remains unchanged. The volume of saving defends upon the level of national income and the saving of the community can increase only when the total income of the community increases. Since expenditure of one person constitutes the income of another person, increase in savings of some individuals will lead to a decline in the incomes and hence expenditures of certain other individuals. Further, a decrease in demand for consumption goods in the economy will decrease the demand for capital goods. The decline in demand for consumption goods as well as for capital goods would lead to a decline in their prices and hence in profits. Declining Profits would discourage investment and thus result in a decline in income, output and employment. In short, a general reduction in consumption would cause a general defficiency of effective demand, leading to a lower level of equilibrium with considerable unemployment. Thus, though saving is a virtue for an individual, it is harmful for the society as a whole. Thus, ‘saving is a vice but not virtue.
So, saving decreases effective demand in the economy resulting a decrease in the price and profit. As a result, investors will be discouraged to invest. This will further decrease the employment, production and income which in turn decreases the saving. This will convert the saving into social evil. So, in the beginning saving is a virtue to the individual but to the society and the nation it will be harmful. Therefore, saving turns into misfortune. This is known as paradox of thrift.
The paradox of thrift can be illustrated graphically as follows:
Above given diagram is showing “paradox of thrift”. In this diagram, income is along on OX-axis and saving and investment along on OY-axis. SS and II curve are the original saving and investment curves respectively. They intersect each other at point E and give us the equilibrium level of income OY at which savings are equal to investment. Now suppose savings in the community increase shifting the SS curve upwards to S1S1 which intersects the old II curve at E1. This lead to a decline in income from OY to OY1. The decrease in income from OY to OY1, results in a reduction in the volume of savings from YE to Y1E1. Thus, the community’s efforts to save more have actually led to a decrease in income as well as savings. If the community attempts to further increase savings which shifts the saving curve to S2S2, then the equilibrium level of income will decline so much that savings as well as investment would become negative. This explains the paradox that attempts to increase aggregate savings would actually lead to a decrease in savings. Therefore, ‘saving is vice not virtue’.