Question

Suppose that people realize that they must save a larger proportion of their income in order to retire, and they simultaneously begin to use new technology that allows them to reduce their holdings of real cash balances as a proportion of their income. Giving reasons, clearly explain the combined impact of these two changes in household behaviour on equilibrium output and interest rates in a closed economy using the IS–LM analysis. You may need to draw a diagram to determine the impact. However, do not provide a diagram with the answer.

Answer 1

First, consider Keynesian money market. In which, interest rate acts equivalent between money demand and money supply in the economy. Demand for money is determined by three factors transaction motive, speculative motive, precautionary motive.

There are two behaviours of consumers given, In one as people realize they need to save more for future they will trade in current consumption for future, i.e, they will keep their money for fixed deposits and earn interest rather than holding money. So, money demand will reduce. Money demand will shift downwards.

In the second case, what is happening here is people real money cash balances been reducing, that purchasing power of money is reduced. As purchasing power reduces i.e., real income falls , this will cause money demand to fall.i.e, money demand curve will shift downwards.

Here due to fall in money demand and interest would fall to I2 in above graph, with this fall interest rate in other side of market that is in goods market, people will start investing because interest rates are low. This would eventually will make money demand to increase a little more, since more money is demanded for transactionary motive.

So, finally due to behavioural changes mentioned above. Interest rate is falling and Income/ output is increasing.