Question

question 4

4. This question concerns how the consumption function affects the analysis of the loanable funds market. Suppose consumption depends on the interest rate, i.e. C = C(Y - T,r). a. b. How will a rise in interest rate affect consumption expenditure and thus national saving? Explain how an increase in government expenditure would affect the economy in the long-run. In particular, explain the effects on investment and consumption. Suppose there is an increase in investment incentive because of some tax reform. Use the loanable fund market to illustrate the effects on interest rates and investment. Compare against the case where the consumption function is C=C (Y-T). c.

Answer 1

Here, Consumption depends on both disposable income and real interest rate, that is,

                                    C = C(Y – T, r)

a) If r increases:

• Savings increases as ‘r’ is the return to savings, that is, S’(r) > 0
• Consumption decreases as ‘r’ is the cost to borrowings, that is, C’(r) < 0

In other words, people want to earn a higher interest income on their savings and also credit becomes dear, decreasing consumption in the process.

b) From Savings-Investment identity, we know:

                                    (Y – C – G) = I [Notations have their usual significance]

An increase in G immediately boosts demand for goods and services. Now since the total output is fixed by factors of production, an increase in G must be offset by decrease in some other components of demand.

Disposable income (Y – T) remains unchanged. So, consumption arising out of changes in disposable income remains unchanged.

So, the increase in G results in a decrease in Investment, I(r), which further results in decrease in rate of interest rate. This phenomenon is known as Crowding-Out Effect.

Now, for consumption arising out of changes in r, C(r) declines and thus correspondingly, S(r) increases, which might boost investment.

c) Considering a decrease in taxes, T by ΔT, disposable income is boosted by ΔT, thus increasing investment. Since now, Savings is dependent on r, an increase in Investment now results in increase in both equilibrium Investment and r. (Fig 1)

In contrast, when C(Y – T), Savings function is independent of r, and is vertical. An increase in Investment now results in increase in only and r. (Fig 2)

SO IL) Vo Iz(1) IO IS Dis sol To I Fig! Figa As I kee from I to I, equilibrium AB I tos from I to Tz, with evestment inneases from I to i s fixed at s, equilibrium r. and & sincreases from rotors. increases from so to re.