Keynes’s Paradox of Thrift

In the great depression of the 1930s, GDP fell, unemployment rose and the UK experienced a long period of deflation. In response to this disastrous economic situation, mainstream economists were at a loss as how to respond. Such a lengthy period of disequilibrium didn’t sit well with Classical theory which expected markets to operate smoothly and efficiently.

One policy the National government did approve was the cutting of unemployment benefits. The rationale was that in times of a depression the govt should set an example by reducing its debt. This example actually inspired members of the public to send in their savings in the hope that it would help the economy.

Alas this is precisely the worst response the Government could have taken. By reducing benefits they further reduced consumer spending and AD. This made areas of high unemployment even more impoverished. When people saved rather than spent their money it just made the recession worse. It was J.M. Keynes who was one of the most enthusiastic proponents of increasing government spending, even if it meant increasing the levels of borrowing. If the govt borrowed they could kick start the economy and hopefully generate a multiplier effect which would enable the economy to start growing.

In the UK and US Keynes was largely ignored until after the war and as a consequence the UK economy experienced high levels of unemployment for the remainder of the decade.

This phenomenon explains why Keynes talked about the “paradox of thrift”. Saving money reduces spending, output and therefore increases the level of unemployment in an economy.

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Perma Link | By: T Pettinger | Tuesday, February 27, 2007
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