In Chapter 2 we said that a higher rate of saving is good for society because it frees resources from consumption uses and directs them toward investment goods. More machinery and equipment means a greater capacity for the economy to produce goods and services. But implicit within this "saving is good" proposition is the assumption that increased saving will be borrowed and spent for investment goods. If investment does not increase along with saving, a curious irony called the paradox of thrift may arise. The attempt to save more may simply reduce GDP and leave actual saving unchanged. Our analysis of the multiplier process helps explain this possibility. Suppose an economy that has a MPC of .75, a MPS of .25, and a multiplier of 4, decides to save an additional $200 billion. From the social viewpoint, a penny saved that is not invested is a penny not spent and therefore a decline in someone’s income. Through the multiplier process, the $200 billion of reduced consumption spending lowers real GDP by $800 billion (4 x $200 billion). The $800 billion decline of real GDP, in turn, reduces saving by $200 billion (= MPS of .25 x $800 billion), which completely cancels the initial $200 billion increase of saving. Here, the attempt to increase saving is bad for the economy: It creates a recession and leaves saving unchanged. For increased saving to be good for an economy, greater investment must accompany greater saving. If investment replaces consumption dollar-for-dollar, aggregate expenditures stay constant and the higher level of investment raises the economy’s future growth rate.

Photograph courtesy of: (c)Arthur S. Aubry/Photodisc #AA010628;