Question

imagine that the Fed decides to take action to restore GDP to the original level from before the increase in saving by American families. What policy would the Fed undertake? Consider the impact of the increased saving behavior and the Fed’s response in a short-run framework with the United States as a closed economy. That is, consider the combined short-run impact of these two developments – increased saving by American families and the Fed response to the increased saving. What would be the combined impact on U.S. GDP, consumption, interest rates, and investment compared to the original equilibrium before either the increase in saving or the response of the Fed? Explain.

Answer 1

IS curve shows the combination of interest rate and real output at which the goods market is in equilibrium and LM curve shows the combination of interest rate and real output at which money market is equilibrium.

IS curve is downward sloping and LM curve is upward sloping.

The point at which IS curve intersects the LM curve is economy's equilibrium point.

The increase in saving rate reduces the consumption expenditure and shifts IS curve to the left.

The graphical representation of IS-LM curve is shown below:

In the figure, initially economy is at equilibrium at point e corresponding to which interest rate is ie and real output is Ye. The increase in saving rate shift IS leftwards to IS' which leads to decrease in interest rate and output.

Fed increases the output by increasing supply of money. The increase in money shifts LM rightwards to LM' and economy is at equilibrium at pint e"' corresponding to which equilibrium output is Ye and interest rate is i".

The decrease in investment discourages savings and encourages investment.

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