In an economy with a marginal propensity to consume of 0.75, people decide to save more, and autonomous consumption falls by Rs 40 crore. At the same time, autonomous investment rises by Rs 40 crore. Which of the following is correct about the new equilibrium?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Income is unchanged, and total saving rises by Rs 40 crore.
Equilibrium income is (C̄ + Ī) ÷ (1 − c). C̄ falls by 40 and Ī rises by 40, so their sum does not change and income stays the same.
In equilibrium, Y = C + I, so saving (Y − C) equals investment. Investment is now 40 more, so total saving is also 40 more.
\( \displaystyle \text{Change in } \bar{C} + \bar{I} = -40 + 40 = 0 \Rightarrow \Delta Y = 0 \)
\( \displaystyle \Delta S = \Delta I = 40 \)
This is not the paradox of thrift. There, people save more but investment does not change, so income falls and saving does not rise. Here investment rises along with thrift.
NCERT (2026-27): “4.2 Determination of Income in Two-sector Model … This equation can be further simplified by adding up the two autonomous terms, C̄ and Ī, making it Y = Ā + c.Y where Ā = C̄ + Ī is the total autonomous expenditure in the economy. In reality, these two components of autonomous expenditure behave in different ways. C̄, representing subsistence consumption level of an economy, remains more or less stable over time. However, Ī has been observed to undergo periodic fluctuations. …” “Paradox of Thrift If all the people of the economy increase the proportion of income they save (i.e. if the mps of the economy increases) the total value of savings in the economy will not increase – it will either decline or remain unchanged. This result is known as the Paradox of Thrift – which states that as people become more thrifty they end up saving less or same as before. This result, though sounds apparently impossible, is actually a simple application of the model we have learnt.” |