Question

Using the circular flow diagram, describe why it is good for one household to increase its savings, but bad when all households increase their savings. This is otherwise known as the Paradox of Thrift. Draw the diagram if you think it will help your explanation.

Answer 1

Answer - Savings provide funds for investment through capital market. Savings are good for some households in economy because it increases income, output and employment. Savings by all households increases saving propensity in the economy. Multiplier effect works for both directions. Multiplier reduces income as savings rise. Increase in saving tendency reduces equilibrium output and income in the economy. Amount of unsold good (inventories) will rise as saving goes up. Manufacturers will cut their output and equilibrium income will fall in the economy. This is known as the Paradox of Thrift.