There is a decrease in income in a closed economy. Derive theimpact of the decrease...

There is a decrease in income in a closed economy. Derive the impact of the decrease in income on the credit market and money market assuming flexible prices. Determine the impact on the equilibrium expected real rate of interest and the price level. Also determine the impact on equilibrium savings, investment, and real balances. You must use graphs to receive full credit.

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Expert Solution

A closed economy is one that has no trading activity with outside economies. This economy is self sufficient to fulfil the domestic demand. There is a decrease in income in a closed economy will decrease demand in the economy and demand decrease its decrease price level and output (real GDP) level. Other side decreasing demand will decrease the demand for money and it will negatively affect the credit market and money market. When the income level will decrease its decrease saving and investment.

income = consumption + saving

And

saving = investment.

When the icome will decrease then it will decrease prive level and decreasing price level means decrease inflation and decreasing inflation means appreciating value of money. It will increase supply of money in the system in respect of value and decrease interset rate. The real interest rate is the inflation adjusted interest rate. Here inflation and interest rate both will decrease so, it will not affect the real interest rate more. But the real interest rate will decraese most of the times in this case. Real balance is the the real purchasing power of a money balance. So, it will increase real balances.

We will understand these affect by AD-AS Model aand IS-LM Model:

You can see the economy is equilibrium at the point "E" and decreasing consumption decrease AD and AD curve shift left from AD to AD1 and the new equilibrium point is "E1" where price and output (real GDP) level are "P1" and "Q1" both are lower than previous level.

Graph:

In IS LM model you can see that decreasing demand or AD level shift IS curve shift left (from IS toIS1) that decrease interest rate and output level.

Graph:

Rahul Sunny answered 2 years ago

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