Question

A decrease in autonomous consumption in a general IS-LM macroeconomic model where consumption, investments, taxes, and money demand are given by the following general functional forms. ?(?, ?), ?(?, ?), ?(?), ??(?, ?) . a. Is there a multiplier effect on output if we hold the interest rate fixed? Explain what would happen to equilibirum

Answer 1

A fall in autonomous consumption will decrease total consumption, which will decrease output. Since Investment, Tax and Money demand are all dependent on output (being co-functions of Y), a fall in Y will lead to a multiplier effect if interest rate is held constant. The magnitude of multiplier effect will depend on marginal propensity to consume (MPC) and marginal propensity to invest (MPI). The higher (lower) the MPC and/or MPI, the higher (lower) the multiplier effect on output caused by lower autonomous consumption.

In equilibrium, therefore, consumption will fall, investment will fall, tax will fall and demand for money will fall. Decrease in output will be higher in magnitude compared to the initial decrease in autonomous consumption.