Macroeconomics: Paradox of Thrift - Assignment Example

Macroeconomics - Paradox of Thrift Economics as we know is the art of managing the financial elements in such a manner that forces of demand and supply make a delicate balance. Economics is further subdivided in macro and micro-economics. Thrift is an integral part of this arrangement which calls for sensible and cautious management of money and goods so that wastage is minimized while maximizing the value. With the help of the paradox of thrift, Keynesian economics has been able to illustrate the differences between macroeconomics and microeconomics. It shows how microeconomic considerations only will seriously jeopardize the macroeconomic factors and the economy as a whole. If everybody in the population starts saving the money, then ideally that should result in an overall higher levels of savings. But John Maynard Keynes, the famous economist, studied this very aspect of thrift and pointed out an interesting paradox. Keynes inferred that if everyone starts saving during times of recession then that would result in falling of the aggregate demand, which in turn will result in lowering the value of total savings in the population and leads to fall in economic growth. He meant to say that thrift is virtuous only up to a limit. The paradox is that an increase in saving, which is a recommended microeconomic strategy when individuals encounter problems, is not the best macroeconomic course of action for the aggregate economy1. Saving in general is composed of two components i. Autonomous saving, which doesn't depend on income ii. Induced saving, which is proportionate to the income levels Therefore, when people try to increase their savings, it may lead to decrease in the levels of autonomous consumption which in turn will decrease the equilibrium income, thus decreasing the induced savings. This way the two components of the savings tend to cancel out each other, implying that even though people tried to increase their savings, the result happened to be a drop in equilibrium income and a 'no change' in savings. That means trying to save more doesn't necessarily result in more saving. It results, instead, in less income out of which to save. Some of the steps involved in this situation and the effects that a chain reaction sets out after such a paradox are; Everybody starts saving his money without spending any of their income. The markets remain idle, as there are no customers and nothing is being sold. Since nothing is being sold, the shop owner starts feeling the pinch and fires his sales-boys and sales-girls. Gradually everyone loses their job. Similarly the production of goods also comes to a halt, and there too employees start loosing their jobs. There is no income as such And since there's no income there is no saving as well. That effectively results in zero savings. This is what John Maynard Keynes studied and objected to. This can further be demonstrated with the help of the Injections-Leakages Model diagrams as shown in the following figures; Fig: The Injections-Leakages Model The two figures shown here depict the paradox of thrift in a convincing manner. For example, if to start with the saving line indicated by 'S' has a positive slope showing gradual increase in savings from a negative saving figure (i.e. expenditure) to a positive saving figure, then the equilibrium of production is achieved by a production of $12 trillion i.e. at the intersection of S and I. Now, anticipating an impending recession, the community (or group of consumers) start increasing their levels of saving i.e. they are now little more on the thrifty side, by curtailing their expenditure plans. Therefore, the community is able to save an amount of $1 trillion more (see fig-2). The saving line is shifted upward and so the point of equilibrium is also shifted. The new saving line intersects original investment line at $8 trillion of aggregate production. This new equilibrium is therefore $4 trillion less than the original equilibrium. As compared to an increase in net saving by $1 trillion, there is a decline of $4 trillion in aggregate production. That means overall disadvantage for the economy of the community. Ahiakpor (1995) states that every year thousands of introductory economics students are made to accept as valid one of Keynes's lasting inversions of classical economics, i.e. the proposition that 'saving may be a private virtue, but is a public vice'. Many economists also agree with this proposition, particularly in this era of globalization and consumerism. But there are many who oppose this paradox. Thies (1996), for example. expresses his strong views on Keynesian paradox and says that in a way Keynesian economics have denigrated the concept of saving, while encouraging wasteful spending, massive deficits and one after another scheme to redistribute wealth. It is The proponents of Liberalization and globalization claim that globalization has opened up newer vistas of trade and business all around the globe. It is said that opening up of economies has now tilted the balance in favor of market forces, which works when products are purchased by the consumers in good numbers. Companies in turn try to make best out of the situation by providing quality at reasonable prices. This helps in keeping the economic activities going on. As a result of globalization market forces have started the policies with the role of respective governments becoming limited in determining the nature of imports and exports. It is now the MNCs who are effectively dictating the policies to the governments. With globalisation, MNCs began to explore the markets outside there domestic grounds. There are countries with economies which are not yet fully opened up for the market forces, but such economies are severely under pressure from the world community and the market forces to fall in line. Examples of China and some other South Asian economies are an example. China has been treading the path of liberalization very cautiously. For long China carried the reputation of being the world's greatest opponent of globalisation. But now things are perceptibly different. Today China has transformed itself into a committed member of WTO. China's accession to the WTO on December 11, 2001, symbolizes its' ongoing integration into the world economy, a transition from government controlled central planning to market-driven principles and significant opportunity for exporters and investors from all across the world. In a way, Keynes appears to have envisaged this type of global community, because according to Keynes, a community that emphasizes the need for increases in its rate of saving would instead end up impoverishing itself and actually saving less, while on the other hand, the community that increases its consumption at the expense of saving would ends up being richer and saving more. For example, it appears China is gradually coming to terms with the forces of globalization and more spending habits. As per the latest statistics, China's major state-owned enterprises (SOEs) reported an increase of 34.8% in combined profits during the first quarter of 2007 as compared to the figures last year (Feng, 2007). Similarly, it was in 1957 that a formal vision of Common European Market was set in motion by the Treaty of Rome, with the aim of increasing economic prosperity and contributing to "an ever closer union among the peoples of Europe" (Wallace & Wallace, 2000). The EU community has traveled a long distance since then. Now with a common currency and a common commercial policy, despite the differences in policy implementations, perception and other interests, today with a share of 18.10% in Goods and 26.4% in services, EU is a major trading partner with the world community, as is evident from the charts below (OECD, 2007). For that very reason, the globalization and liberalization has become such a craze that now economies try their level best to facilitate the market forces to such an extent that at times, it becomes a pain the neck. Glaring examples of such rush of blood are the Mexican currency crisis and the South-East Asian crisis, which almost resulted in failed states when the rulers tried to follow the market forces, without actually taking a look at the preparedness for such venture. In practice therefore, savings are a necessicity, but not at the cost of other economic activities in the country. References: 1. Ahiakpor, James C.W. (1995). A paradox of thrift or Keynes's misrepresentation of saving in the classical theory of growth Southern Economic Journal, Vol. 62. 2. AmosWeb (2007). Paradox of Thrift. Available online at http://www.amosweb.com/cgi-bin/awb_nav.pls=wpd&c=dsp&k=paradox+of+thrift (July 13, 2007) 3. Frank, Ellen (2004). No More Savings!, Dollars & Sense, 00125245, May/Jun2004, Issue 253 4. Feng, Chen (2007). 'Major SOE profits up 34.8% in 1st quarter'. Xinhua News agency (2007-05-04). Available online at http://news.xinhuanet.com/english/2007-05/04/content_6056641.htm (July 12, 2007) 5. OECD (2007). Economic Policy Reforms: Going for Growth 2007 - European Union Country Note. Available online at http://www.oecd.org/dataoecd/48/19/38088845.pdf (July 12, 2007) 6. Thies, Clifford F (1996). The paradox of thrift: RIP., CATO Journal, 02733072, Spring/Summer96, Vol. 16, Issue 1 7. Wallace, Helen and Wallace, William (2000). Policy-Making in the European Union. 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