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Children are taught to ¡°save for a rainy day¡±, as it is considered the preparation for a safer, possibly better, future. However, one of John Maynard Keynes¡¯ early theory suggested that the attempt by the economy as a whole to increase aggregate of saving will not only fail, but may lower aggregate output, income and employment. It is later called the ¡°Paradox of saving¡± (or ¡°Paradox of thrift¡±). The main reason is because increased saving means decreased consumption, at a given level of income; and the stimulating effect of investment and other spending will be reduced by the smaller marginal propensity to consume. For example, suppose that an economy has the following consumption function: C= c0+ c1YD=$100+0.8YD The multiplier therefore is 1/(1-0.8)=5 And the autonomous investment (I) is equal to $300 billion, the equilibrium level of income (and output) is YE=[1/(1-c1)] (c0+I)=5(100+300)=$2000 Aggregate consumption C=100+0.8¡Á2000=$1700 Aggregate saving S=YD-C=YE-C=2000-1700=$300=I Therefore aggregate saving equals to aggregate investment Further assume, it is suggested that we should save more in order to grow, and people follow by increasing their propensity to save from (1-0.8) to 0.25. Now C=100+0.75YD The new multiplier is 1/0.25=4 Thus new aggregate equilibrium level of income and output is Y¡¯E=[1/(1-c1)] (c0+I)=4(100+300)=$1600 The new aggregate consumption C¡¯=100+0.75¡Á1600=$1300 New aggregate saving S¡¯=1600-1300=$300 As can be seen, saving still stayed at the same level ($300 billion) as before, equaled to investment, whereas national income level (and output) was lowered by $400 billion in figure.
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