Question

1. Saving and Investment
(a). Consider the consumption expenditure function

? = ?̅ + ?(? − ?, ?)

In each sentence below, fill in the blank with either: increasing, decreasing, or constant. Consumption is a/an __________________ function of disposable income. Consumption is a/an __________________ function of the real interest rate.

(b). National saving can be written as

?=?−?−?

Substitute the consumption expenditure function from part (a) into this equation. That is, write an equation for saving S that depends on disposable income, the real interest rate, and other factors.

Using this expression, fill in the blank below with either: increasing, decreasing, or constant. Saving is a/an __________________ function of the real interest rate.

(c). Consider the consumption expenditure function

? = ?̅ + ?(?)

In the following sentence, fill in the blank with either: increasing, decreasing, or constant.

Investment is a/an __________________ function of the real interest rate.
(d). Consider a closed economy. Graph the saving and investment functions. Label all of the elements of your graph clearly. Label the equilibrium real interest rate (?∗) and the equilibrium quantities of saving (?∗) and investment (?∗) on your graph.

(e). Suppose there is a reduction in government consumption. Shift a curve (or curves) in your graph above to show what changes.
(Hint: Look at parts (a) – (c). How does a change in government consumption affect the savings function? The investment function?)

(f). For each of the following variables, does it increase, decrease or remain unchanged after the change in government consumption?

Saving: _________________ Investment: _________________ Real interest rate: _________________

(g). Now consider a small open economy. Suppose the world interest rate rw is lower than the equilibrium real interest rate in your answer to part (d). Are net exports positive or negative for this economy? Explain briefly.

Answer 1

1. a) Consumption is an increasing function of disposable income. Consumption is a decreasing function of real interest rate.

b) Saving is an increasing function of real interest rate.

c) Investment is a decreasing function of real interest rate.

d)

e) A reduction in government consumption would cause an increase in savings, i.e. a rightward shift of the Savings function.

f) Saving: increases. Investment: decreases. Real interest rate: decreases.

g) The net exports will be positive as a higher domestic equilibrium real interest rate compared to world interest rate would attract more foreign investment and incentivise domestic investors to invest within the country itself.