What happens in the Keynesian model if households decide to be “thriftier”—that is, spend less and save more? Do the following multistep exercise to find out.

 

a. Suppose that the economy starts out in a situation we already developed in the text:  = 20 + .8Y and I_I = 60 (see Table 24.3). Carefully graph the resulting AD curve, labeling the levels of aggregate demand that result when income is equal to 0, 300, 400, and 500. Label the curve AD₀, add the 45° line, and label the equilibrium point E₀.

b. What is the equilibrium level of income in this initial case? What is the equilibrium level of saving?

c. Now suppose that people decide they want to save more of their income and spend less of it. In fact, their new level of autonomous consumption is 0, so the new consumption function is just C = .8 Y. Calculate the levels of consumption and aggregate demand that would result from incomes of 0, 300, 400, and 500. (You might want to set up a table similar to Table 24.3, but using this new equation for consumption. Intended investment is still 60.)

d. If income stayed at the equilibrium level determined in step (b) of this question, would people now be saving more? How much more? Show your work.

e. Add the AD curve that arises from your calculations in step (c) on the graph that you drew earlier. Label this curve AD₁ and the new equilibrium point E₁.

f. What is the new equilibrium level of income? What is the new equilibrium level of saving? Compare your answers to your answers in step (b).

g. Explain why this phenomenon arising from the Keynesian model is called “the paradox of thrift.” Can you explain why this “paradox” arises?