Question

For each of the following scenarios, use the goods market (investment-saving) diagram to identify changes in saving and investment curves. Provide a separate diagram with original and new curves for each scenario. Determine the changes in the interest rate and equilibrium quantities of investment and saving.

a. An expected increase in households’ income.

b. A rise in expected future marginal productivity of capital.

c. An increase in current output (income).

Answer 1

In following graphs, I0 and S0 are initial investment and saving curves, intersecting at point A with initial interest rate r0 and quantity of saving and investment Q0.

(a)

Higher expected future income causes households increase current consumption. This reduces current savings, shifting savings curve to left. Interest rate increases and equilibrium quantity of saving and investment decreases.

In following graph, S0 shifts left to S1, intersecting I0 at point B with higher interest rate r1 and lower quantity of saving and investment Q1.

(b)

Higher expected future marginal productivity of capital increases expected profitability, hence firms increase business investment, shifting investment curve to right. Interest rate increases and equilibrium quantity of saving and investment increases.

In following graph, I0 shifts right to I1, intersecting S0 at point B with higher interest rate r1 and higher quantity of saving and investment Q1.

(c)

Higher current income increases both current consumption and current savings. This shifts savings curve to right. Interest rate decreases and equilibrium quantity of saving and investment increases.

In following graph, S0 shifts right to S1, intersecting I0 at point B with lower interest rate r1 and higher quantity of saving and investment Q1.