chapter 22 deriving equilibrium national income gottheil — principles of economics, 7e © 2013...

Chapter 22Chapter 22

DERIVING EQUILIBRIUM DERIVING EQUILIBRIUM NATIONAL INCOMENATIONAL INCOME

Gottheil — Principles of Economics, 7e© 2013 Cengage Learning1

Economic PrinciplesEconomic Principles

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Aggregate expenditure

The equilibrium level of national income

The relationship between saving and investment

The income multiplier

Economic PrinciplesEconomic Principles

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The relationship between aggregate expenditure and aggregate demand

The paradox of thrift

Equilibrium National IncomeEquilibrium National Income

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Equilibrium price is determined by the equal contribution of both demand and costs of production. In particular, it is their interaction that determines equilibrium price.

Equilibrium National IncomeEquilibrium National Income

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Similarly, the interaction of aggregate expenditure and aggregate supply contribute to equilibrium national income. In this case, however, aggregate expenditure plays a stronger role than aggregate supply.

Interaction Between Interaction Between Consumers and ProducersConsumers and Producers

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Aggregate expenditure

• Spending by consumers on consumption goods, spending by businesses on investment goods, spending by government, and spending by foreigners on net exports.

Interaction Between Interaction Between Consumers and ProducersConsumers and Producers

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Recall that the amount of consumer income spent on consumption and saving is represented by:

Y = C + S

Interaction Between Interaction Between Consumers and ProducersConsumers and Producers

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And recall that the amount of production goods and investment goods produced by producers is represented by:

Y = C + Ii

where the subscript i indicates intended as distinct from actual.

Interaction Between Interaction Between Consumers and ProducersConsumers and Producers

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If, by chance, what producers intend to produce for consumption turns out to be precisely what consumers intend to consume, the match between intended investment and savings is written as:

Ii = S

Interaction Between Interaction Between Consumers and ProducersConsumers and Producers

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The I = S equation describes the economy in macroequilibrium. No excess demand or supply exists. Aggregate expenditure equal aggregate supply.

The Economy Moves Toward The Economy Moves Toward EquilibriumEquilibrium

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The national economy, if not already in equilibrium, is always moving toward it.

The Economy Moves Toward The Economy Moves Toward EquilibriumEquilibrium

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Equilibrium level of national income

• C + Ii = C + S, where saving equals intended investment.

The Economy Moves Toward The Economy Moves Toward EquilibriumEquilibrium

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Unwanted inventories

• Goods produced for consumption that remain unsold.

The Economy Moves Toward The Economy Moves Toward EquilibriumEquilibrium

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Actual investment (Ia)

• Investment spending that producers actually make, which is, intended investment (investment spending that producers intend to undertake) plus or minus unintended changes in inventories.

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EXHIBIT 1 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $900 BILLION

Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $900 Billion = $900 Billion

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Suppose the economy is at Y = $900 billion, autonomous consumption = $60 billion, MPC = 0.80 and producers’ intended investment is $100 billion.

Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $900 Billion = $900 Billion

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1. What are consumers’ consumption expenditures and savings in Exhibit 1?

• If Y = C + S and C = a + bY, then consumption expenditures (C) = $60 billion + 0.8 ($900 billion) = $780 billion.

Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $900 Billion = $900 Billion

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1. What are consumers’ consumption expenditures and saving in Exhibit 1?

• If S = Y – C, then saving (S) = $900 billion – $780 billion = $120 billion.

Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $900 Billion = $900 Billion

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2. What is intended production by producers?

• If C = Y - Ii and Ii = $100 billion, then intended production = $900 billion - $100 billion = $800 billion.

Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $900 Billion = $900 Billion

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• Producers’ intended production ($800 billion) – consumers’ consumption expenditures ($780 billion) = $20 billion.

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $900 Billion = $900 Billion

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• The $20 billion difference is described as unwanted inventories and must be absorbed as investment.

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

Exhibit 1: Consumers’ and Exhibit 1: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $900 Billion = $900 Billion

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3. What is the difference between producers’ intended production and consumers’ consumption expenditures?

• Producers’ actual investment ($120 billion) ends up being greater than what they had intended to invest ($100 billion).

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EXHIBIT 2 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $700 BILLION

Exhibit 2: Consumers’ and Exhibit 2: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $700 Billion = $700 Billion

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Suppose national income changes to Y = $700 billion, but MPC, autonomous consumption and intended investment all remain the same.

Exhibit 2: Consumers’ and Exhibit 2: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $700 Billion = $700 Billion

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1. What are consumers’ consumption expenditures?

• C = $60 billion + 0.8 ($700 billion) = $620 billion

Exhibit 2: Consumers’ and Exhibit 2: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $700 Billion = $700 Billion

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2. What is intended production by producers?

• C = $700 billion – $100 billion = $600 billion

Exhibit 2: Consumers’ and Exhibit 2: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $700 Billion = $700 Billion

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• Consumers’ consumption ($620 billion) – Producers’ production ($600 billion) = $20 billion

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

Exhibit 2: Consumers’ and Exhibit 2: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $700 Billion = $700 Billion

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• The $20 billion difference must be converted from intended investment to consumption goods to meet demand.

3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

Exhibit 2: Consumers’ and Exhibit 2: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $700 Billion = $700 Billion

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3. What is the difference between consumers’ consumption expenditures and producers’ intended production?

• Actual investment ends up being less than intended investment.

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EXHIBIT 3 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN Y = $800 BILLION

Exhibit 3: Consumers’ and Exhibit 3: Consumers’ and Producers’ Intentions and Activities, Producers’ Intentions and Activities,

by Stages, When by Stages, When YY = $800 Billion = $800 Billion

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What is the difference between production and consumers’ expenditures in Exhibit 3? • Production and consumption are equal at

$700 billion. The economy is in equilibrium.

Equilibrium National IncomeEquilibrium National Income

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Aggregate expenditure curve (AE)

• A curve that shows the quantity of aggregate expenditures at different levels of national income or GDP.

Equilibrium National IncomeEquilibrium National Income

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Aggregate expenditure curve (AE)

• The intersection of the 45° income curve and AE identifies the economy’s equilibrium position.

Equilibrium National IncomeEquilibrium National Income

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• When Ii > S, producers hire more workers to replace depleted inventories. Y increases and continues to increase until Ii = S.

• When S > Ii, inventories build up and producers lay off workers. Y decreases until Ii = S.

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EXHIBIT 4A THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

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EXHIBIT 4B THE EQUILIBRIUM LEVEL OF NATIONAL INCOME

Exhibit 4: The Equilibrium Level Exhibit 4: The Equilibrium Level of National Incomeof National Income

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At a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4.i. Greater than

ii. Less than

Exhibit 4: The Equilibrium Level Exhibit 4: The Equilibrium Level of National Incomeof National Income

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At a national income of $700 billion, aggregate expenditure is ____ the national income in panel a of Exhibit 4. i. Greater than

ii. Less than

Changes in Investment Change Changes in Investment Change National Income EquilibriumNational Income Equilibrium

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As long as the consumption function and the investment demand function remain unchanged, there is no reason to suppose that the level of national income would move away from equilibrium.

Changes in Investment Change Changes in Investment Change National Income EquilibriumNational Income Equilibrium

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Functions do change, however.

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EXHIBIT 5 CONSUMERS’ AND PRODUCERS’ INTENTIONS AND ACTIVITIES, BY STAGES, WHEN INVESTMENT INCREASES TO $130 BILLION AND Y = $800 BILLION

Exhibit 5: Consumers’ and Producers’ Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, Intentions and Activities, by Stages, when Investment Increases to $130 when Investment Increases to $130

Billion and Billion and YY = $800 Billion = $800 Billion

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• When intended investment increases, the supply of consumption goods decreases to $670 billion.

What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

Exhibit 5: Consumers’ and Producers’ Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, Intentions and Activities, by Stages, when Investment Increases to $130 when Investment Increases to $130

Billion and Billion and YY = $800 Billion = $800 Billion

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• Consumers’ consumption expenditures remain at $700 billion. Consumers’ demand is greater than producers’ production.

What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?

Exhibit 5: Consumers’ and Producers’ Exhibit 5: Consumers’ and Producers’ Intentions and Activities, by Stages, Intentions and Activities, by Stages, when Investment Increases to $130 when Investment Increases to $130

Billion and Billion and YY = $800 Billion = $800 Billion

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What happens to the equilibrium level of national income when intended investment increases in Exhibit 5?• In an effort to meet consumers’ demand,

producers hire more workers and national income increases. The equilibrium also increases.

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EXHIBIT 6A DERIVING EQUILIBRIUM AT Y = $950 BILLION

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EXHIBIT 6B DERIVING EQUILIBRIUM AT Y = $950 BILLION

Exhibit 6: Deriving Equilibrium Exhibit 6: Deriving Equilibrium at at YY = $950 Billion = $950 Billion

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What is the equilibrium level of national income when intended investment increases to $130 billion in Exhibit 6?• The equilibrium level increases to

$950 billion, where Ii = S.

Changes in Investment Change Changes in Investment Change National Income EquilibriumNational Income Equilibrium

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The formula Y = (a + bY) + Ii can be used to calculate equilibrium national income when specific values for autonomous consumption, MPC and intended investment are known.

The Income MultiplierThe Income Multiplier

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While consumption spending, MPC, and autonomous consumption have all remained relatively stable over time, investment spending has been volatile.

The Income MultiplierThe Income Multiplier

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Economists identify changes in aggregate expenditure, in particular investment spending, as the key to our understanding of why national income changes.

The Income MultiplierThe Income Multiplier

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Income multiplier

• The multiple by which income changes as a result of a change in aggregate expenditure. It is written as:

Multiplier = (Change in Y)/(Change in AE)

The Income MultiplierThe Income Multiplier

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The size of the multiplier depends on the marginal propensity to consume. An initial change in investment sets in motion a chain of events that creates a larger change in national income.

The Income MultiplierThe Income Multiplier

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For example, suppose a business owner decides to invest $1,000 in a new technology. The producer of the technology receives an increase in income of $1,000. If MPC = 0.80, the technology producer’s consumption spending increases by $800.

The Income MultiplierThe Income Multiplier

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Suppose the $800 is then spent on a custom-made water bed. The carpenter that makes the water bed receives $800 of additional income. Based on MPC, we know that she will spend $640 and save the rest. The chain of events continues.

Changes in Foreign Trade Change Changes in Foreign Trade Change National Income EquilibriumNational Income Equilibrium

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The influence of foreign trade on national income determination is less obvious than are the other components of aggregate expenditure. It includes both exports and imports, which have offsetting effects on the direction a national economy takes.

.

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EXHIBIT 7 IMPACT OF FOREIGN TRADE ON NATIONALINCOME EQUILIBRIUM

Exhibit 7: Impact of Foreign Trade Exhibit 7: Impact of Foreign Trade on National Income Equilibriumon National Income Equilibrium

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In panel a, the AE curve shifts upward by $60 billion of exports, increasing national income to $1,100 billion. • This is effect those exports have on theU.S.

economy’s equilibrium.

Exhibit 7: Impact of Foreign Trade Exhibit 7: Impact of Foreign Trade on National Income Equilibriumon National Income Equilibrium

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In panel b, the AE curve shifts downward by $20 billion of imports, decreasing national income by $100 billion.• This is the impact of imports on aggregate

expenditure.

Exhibit 7: Impact of Foreign Trade Exhibit 7: Impact of Foreign Trade on National Income Equilibriumon National Income Equilibrium

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In panel c, the combined effect of exports and imports shifts the AE curve upward by $40 billion ($60 – $20) of foreign trade, increasing national income by $1,000.• That is, what was once AE = C + I is now AE

= C + I + (X - M).

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EXHIBIT 8 THE MAKING OF THE INCOME MULTIPLIER

Exhibit 8: The Making of the Exhibit 8: The Making of the Income MultiplierIncome Multiplier

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The additions to national income in Exhibit 8 become _____ as economic activity progresses through successive rounds.i. Smaller and smaller

ii. Bigger and bigger

Exhibit 8: The Making of the Exhibit 8: The Making of the Income MultiplierIncome Multiplier

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The additions to national income in Exhibit 8 become _____ as economic activity progresses through successive rounds.i. Smaller and smaller. For example, in round 2,

$800 is added. In round 3, $640 is added.

ii. Bigger and bigger

The Income MultiplierThe Income Multiplier

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The formula to determine the income multiplier is written:

1/(1 – MPC)

Since (1 – MPC) = MPS, the formula can be written:

1/MPS

The Income MultiplierThe Income Multiplier

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For example, for a $1,000 change in investment, when MPC = 0.80, the income multiplier is:

1/(1 – 0.80) = 1/(0.2) = 5

A $1,000 investment leads to a $5,000 change in national income.

The Income MultiplierThe Income Multiplier

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Just as increases in aggregate expenditure stimulate the economy, cuts in aggregate expenditure drag it down.

The Paradox of ThriftThe Paradox of Thrift

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Some people believe that putting a higher percentage of their income into saving will provide greater economic security. This is not necessarily the case, however. By trying to save more, people may actually end up saving less, or at least saving no more.

The Paradox of ThriftThe Paradox of Thrift

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The paradox of thrift

• The more people try to save, the more income falls, leaving them with no more and perhaps even less saving.

The Paradox of ThriftThe Paradox of Thrift

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The intention to save more causes the saving curve to shift upwards. Saving then becomes greater than intended investment (S > Ii). The equilibrium level of national income falls.

The Paradox of ThriftThe Paradox of Thrift

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• If the level of intended investment curve is horizontal, then the level of saving remains unchanged.

• If the intended investment curve is upward sloping, then the level of saving declines.

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EXHIBIT 9 THE PARADOX OF THRIFT

Exhibit 9: The Paradox of ThriftExhibit 9: The Paradox of Thrift

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1. What happens to national income and saving when the saving curve shifts from S to S′ in panel a of Exhibit 9?

• National income falls from $800 billion to $650 billion. Saving remains unchanged.

Exhibit 9: The Paradox of ThriftExhibit 9: The Paradox of Thrift

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2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

• The equilibrium level of national income falls from $800 billion to $550 billion.

Exhibit 9: The Paradox of ThriftExhibit 9: The Paradox of Thrift

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• Because the intended investment curve is upward sloping, the shift in the saving curve causes a decline in the level of investment as well.

2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

Exhibit 9: The Paradox of ThriftExhibit 9: The Paradox of Thrift

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• Saving falls from $100 billion to $75 billion.

2. What happens to national income and saving in panel b when the saving curve shifts from S to S′?

The Paradox of ThriftThe Paradox of Thrift

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Increased saving is not always detrimental to our economic health. If accompanied by increased investment, increased saving is both inevitable and desirable.

The Paradox of ThriftThe Paradox of Thrift

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During the 2008–2011 recession:

The inclinations of consumers to increase their saving and of producers to hold off on intended investment might have augmented both the decline in national saving and national income