Question

Consider an economy in the short-run described by the following equations:

Z = C + I + G

G = 500

T = 500

C = 200 + 0.75(Y – T)

I = 425 + 0.05Y

Suppose that consumers decide to consume less (and therefore save more) for any given amount of disposable income. Specifically assume that consumer confidence falls and C = 200 + 0.75(Y-T). Assume the initial function for I = 425 + 0.05Y and the initial value of G = 500.

a. What happens to equilibrium output?

b. What will the investment be now in equilibrium?

c. What will happen to private and public saving? What happens to consumption?

d. Comment on the following logic: “When output is too low, what is needed is an increase in demand for goods and services. Investment is one component of demand, and saving equals investment. Therefore, if the government could just convince households to attempt to save more, then investment and output would increase.”

Answer 1

a. The equilibrium output will be where we have Y=C+I+G. Given the original consumption function and also investment function the equilibrium output will be as follows:

If consumers consume less and save more, equilibrium output will fall. The output level will thus fall from the original output level of 3750 above.

b. The new investment function is unknown. As per the original investment function, the investment will be I=425 + 0.05(3750) = 612.5. The new investment function is not given and so is unknown. If consumption falls then investment falls as output falls.

c. As consumption falls this will mean that savings will rise. Private savings will increase as consumption falls. The level of public savings will be given by the difference between taxes and government spending. This will increase as the savings level increases overall. Consumption will decline as the output level falls.

d. What needs to be considered here is the time lag. An increase in savings will mean that capital accumulation occurs but after a significant time lag. This in turn is brought about by an increase in investment. This results in a rise in output over time. The statement is incorrect as does not consider the time lag.