Question

6. (14 pts) There is a decrease in income in a closed economy. Derive the impact of the decrease in income on the credit market and money market assuming flexible prices. Determine the impact on the equilibrium expected real rate of interest and the price level. Also determine the impact on equilibrium savings, investment, and real balances. You must use graphs to receive hill credit

Answer 1

Answer : Decrease in closed economy will create decline in consumption and savings. Low income will induce people to demand for money for maintaining previous standard of living in form of loans and credits which will exceed supply of money. When demand of money will be exceeding supply of money, it means more credit will be demanded then supply of credit which will rise interest rates of credits.

In above diagram when demand for credit increase from D1 to D2 then interest rate will rise to i1 to i2.

In money market, instruments will be sold off by people so as to maintain previous living standards this will create more supply of money market instruments and less demand of money market instruments. This will decrease value of money market instruments as supply is more than demand due to low income.

Real rate of interest will raise as due to low profits and low investments that is only because of low income. Similarly there will be decrease in prices as due to low income less people will demand for goods and services than supply so price will be decrease as supply is more than demand.

Savings, investments and real balances all three will decrease as all above three are directly proportional to income of consumer. In other words low income will be resulting in low savings , low investments and low real balances.

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