Consumption and Saving, Again

Here's the point: in order to increase their saving, people have to cut back on consumption.

Remember, saving is income minus consumption. It follows that an increase in saving is a decrease in consumption. So we rephrase the question: why would people want to increase their saving? Savings provide a reserve in times of uncertainty. When people feel that the future is more uncertain -- that they may lose their job or their business may fail -- that would give them reasons to increase their saving, and, conversely, cut back on consumption. Perhaps that is what happened in the early 1930's. The stock market crash of 1929, bank failures and other events certainly gave people reason to feel the future was uncertain.

And yet, there is a paradox here. Let's look back at our example, and compare saving before and after the change in the consumption function.

Before: S = Y-C = Y - 500 - 0.7*Y = (1-0.7)*Y - 500 = 0.3*Y - 500 = 0.3*5000 - 500 = 1500 - 500 = 1000 -- so saving was 1000, the same as investment.
After: S = Y-C = Y - 0.7*Y = (1-0.7)*Y = 0.3*Y = 0.3*3333.33 = 1000 -- so saving was 1000, the same as investment.

Although everyone has increased their saving targets, there has been no increase in overall saving! Instead, production has dropped just enough to bring saving back to its original level. How can this be?

The Paradox of Thrift