The (less paradoxical) paradox of saving A chapter problem at the end of Chapter 3 considered the effect of a drop in consumer confidence on private saving and investment, when investment depended on output but not on the interest rate. Here, we consider the same experiment in the context of the IS-LM framework, in which investment depends on the interest rate and output but the central bank moves interest rates to keep output constant.

a. Suppose households attempt to save more, so that consumer confidence falls. In an IS-LM diagram where the central bank moves interest rates to keep output constant, show the effect of the fall in consumer confidence on the equilibrium in the economy.

b. How will the fall in consumer confidence affect consumption, investment, and private saving? Will the attempt to save more necessarily lead to more saving? Will this attempt necessarily lead to less saving?