An increase in saving by the household sector necessarily goes hand-in-hand with a simultaneous decrease in consumption expenditures, and thus a decrease in aggregate expenditures. This decrease in aggregate expenditures then triggers the multiplier process and subsequently leads to a decrease in aggregate production. To the extent that saving and investment are both induce by changes in aggregate production and income, the saving is likely to paradoxically decrease below the level that existed before the initial change.

The Fallacy of Composition

This fallacy is most important for complex systems, such as the macroeconomy or the human body, that is composed of numerous different parts. The human body contains different organs, different types of cells, different components, all of which function separately and work together in the operation of the entire body. In a like fashion, the macroeconomy contains different markets, industries, buyers, sellers, consumers, and producers. These components are function separately but come together in the operation of the aggregate economy.

The paradox of thrift is one of the better know examples of the fallacy of composition found in the study of macroeconomics. It demonstrates that what might be true for the part (more saving is better for an individual) is not necessarily true for the whole (more saving can be worse for the economy).

The Injections-Leakages Model

The S-I Model

Saving More

In total, the household sector increases saving by $1 trillion. Because this extra saving is NOT the result of a change in income it is an autonomous change. The increase in saving thus shifts the saving line upward. Click the [Increase Saving] button to illustrate.

The result of this increase in saving is a new equilibrium. The new saving line intersects original investment line at $8 trillion of aggregate production. This new equilibrium is $4 trillion less than the original equilibrium. Concerns by the household sector of an upcoming recession, the act saving more to protect against an economic downturn, has in fact caused a downturn.

What happened?

The $1 trillion increase in saving necessitates a $1 trillion decrease in consumption. This is an autonomous decrease in consumption and like other autonomous expenditure changes, triggers the multiplier process that causes the $4 trillion decline in aggregate production. More saving means less production.

Induced Investment

The Paradox

The exhibit to the direct right illustrates an updated version of the saving-investment model that includes induced investment. The investment line, I, in this exhibit is positively-sloped. An increase in aggregate production induces an increase in investment expenditures. Or more to the point, a decrease in aggregate production induces a decrease in investment expenditures.

To illustrate how this change creates a paradoxically result, click the [Increase Saving] in this exhibit. The $1 trillion vertical shift of this saving line is identical to the earlier exhibit. The result, however, is slightly different.

The new equilibrium is achieved at the intersection of the new saving line and the original investment line. However, in this case equilibrium level of aggregate production is $6 trillion rather than $8 trillion. But that's not the paradox.

The paradox arises because the equilibrium level of saving is LESS. Prior to the autonomous increase in saving, saving and investment were equal at $2 trillion. However, because investment is induced, the decrease in aggregate production causes a decrease in investment and thus the NEW equilibrium equality between investment and saving is $1.5 trillion, less than the original $2 trillion level.