Question

Assume that the decrease in the saving rate occurred because of a new government policy that compelled people to save less. Let’s think about whether people are made better off by this policy. We often take GDP per capita as a guide to living standards. But for this question, it is important to think about consumption per capita, which is the share of output not saved. To do this, we need to distinguish between the short and the long run effects. What happens in the short-term? Are people better or worse off in the short term? By short-term here, we refer to the exact period in which the change in policy is implemented.

What happens in the long-term? Are people better or worse off in the long-term? By longterm here, we refer to new steady state. You may want to use the equation that you have obtained for C ∗ to justify your answer.

Answer 1

If the government takes up a policy in which people start consuming more and saving less, then the immediate short run effects are that on increasing consumption, the Gross Domestic Product increases as:

GDP = C + I + G + (X-M), where C is the consumption, I is investment, G is government spending and X-M is the net exports.

In the short run, output and prices are sticky so on increasing consumption, the demand for goods and services rise and thus people's savings fall as a result.

In the long run, however when everything gets adjusted in this time period increase in consumption, ceteris peribus also increases the production of goods and services. This increased demand for goods lead to an increase in the income of people because of a rising employment in the economy too. However since the savings fall, the investment expenditure also fall which acts in the opposite direction of the increase in consumption. Thus there is an ambiguity regarding which effect dominates in the economy.