Useful Notes on Paradox of Thrift
For the development planners, on the other hand, this thriftiness (habit to save) of the people is a vice because it affects national income adversely. Fig. 6.4 demonstrates the fact.
The figure shows how nation’s mutton turns households’ poison and households’ mutton, the nation’s poison. At a point of time, if savings prove a boon to households, they prove a bane to the nation or if they prove a boon to a nation they prove a bane for the households. Different implications of savings to different entities at a point of time are referred to as the Paradox of Thrift.
The problem can be resolved if the households possess highly developed banking habits and if the banking network is wide and capable of attracting the households’ savings as bank deposits. In that case, savings deposits with the banking sector can be used to finance growth of income and development of the nation as a whole without making the households feel insecure.
Bankers can assure the households a perpetual liquidity of deposits through the ATM facility and at the same time can employ the idle vault cash to finance productive ventures through their credit creation. An instrument of credit creation is the credit multiplier, defined as the ratio of the total deposits to the primary deposits.
To demonstrate, suppose household deposits Rs 100 per month in a savings deposit. The bankers, suppose, retain 20% of the deposit as vault cash to encash the depositor’s cheques and the rest, 80%, they feel free to lend out on interest.
The proportion of deposits retained by the bankers as vault cash is known as their cash reserve ratio, r, which results in a credit multiplier, K = 1/r. It is 5.00 when r = 20%. With the credit multiplier of 5.00, the total volume of subsequent deposits generated by lending activity of the bankers is K times the primary deposit or Rs 500 [5 x 100, See Section 9.4 also]. This may serve the households’ cause of thriftiness and the nation’s cause of growth of output simultaneously.