Question

UK is small open economy with a flexible exchange rate regime and perfect capital mobility. Suppose that the consumption function shifts down, due perhaps to a worsening of consumer confidence. That is, for every level of disposable income, consumers want to consume less. Explain the direction of the effect of this change on output, consumption, investment, interest rate, net exports and exchange rate.

Answer 1

There exist a positive relationship between consumption and disposable income .when disposable income decreases a partition of their income used for consumption also decreases and it led to a downward shift in the consumption function. when consumers reduce their demand output may adversely be affected , a lesser quantity of output is required to produce .when individuals have more disposable income with their hands the banks may increase the interest rates to be paid for the loans and securities.as a result of the decline in consumption the demand for imports may decrease and net export may increase and when consumption decrease demand may decrease and also price decline which led to depreciation and lower the exchange rate.people substitute their consumption by savings which may led to much more investment