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. (125 words maximum)

Answer 1

Lets first understand what the IS (Investment Savings) and LM (Liquidity Preference-Money supply) curve represents. This is only for understanding. Dont use to submit your answer as word limit is 125. Use the second part of answer to submit.

The equilibrium GDP will be where the IS and LM curves meet. The IS curve is shows Investment and saving. The higher the customers save, less they invest. The LM curve shows the lesser the people’s preference for liquidity (cash etc), the higher the money supply.

Submit from here-

As investment and/or money supply increase, GDP increases.

It’s given that people have started saving more, meaning people are investing less- shifting IS curve to left. This decreases GDP and lowers interest rate. Also, its given that people are now holding less cash, meaning money supply has increased. This shifts the LM curve to right, increasing GDP and decreasing interest rate further.

So, these two effects will cancel out as far as GDP is concerned. The new GDP will be about same but interest rate will far lower.