Determination of Income and Employment — Economics STD 12 Humanities & Commerce — Question

Paradox of thrift: Since start of human civilisation it was considered a virtue to keep consumption level at the minimum but the lasting effects and chain reactions of keeping consumption in check were not realised. People were taught that thrift or savings are good because a penny saved today will bring increased income. In this connection, Keynes pointed out paradox of thrift and showed that as people become more thrifty, they end up saving less or same as before. If all the people of an economy increased the proportion of income which is saved (i.e., MPS), the value of savings in the economy will not increase, rather it will decline or remain unchanged. Let us understand this statement with the help of the figure.
In Fig, initial saving curve is SS and investment curve is II. Economy attains equilibrium (saving = investment) at E and equilibrium level of income is OY. Now, suppose the society decides to become thrifty and increases saving by, say, AE. As a result saving curve shifts upward to S₁S₁ intersecting investment curve II at E₁ Unplanned inventories will increase and firms will cut down production and employment and move to new equilibrium E₁ The Figure shows that in the end, planned saving has fallen from AY to E₁Y₁. Notice at new point of equilibrium E_1,, the investment level and also realised saving remain the same (E₁Y₁) but level of income has fallen from OY to OY_1. The decline in equilibrium level of income shows the paradox of thrift as the reverse process of multiplier has worked on reducing consumption expenditure. In fact, increased saving is virtually a withdrawal from circular flow of income.