Question

II. Consumption, Saving and Government Budget again

Now the economy is doing very strong, and we can assume it is under full employment (long run) equilibrium. However, suppose households are uncertain about what events and policies may lie ahead, and decide to cut back consumption spending.

(1) What short run and long run impacts would you expect this increased saving (decreased consumption) have on the economy, specifically on output (Y), price level (P), inflation (∏), real interest rate (r), nominal interest rate (i), and government budget (T- G)? [No need to show the long run effect in IS-LM framework]

(2) Now suppose the government has adopted a strict balanced budget policy that mandates that G=T each year. When people cut back their 2 consumptions (and before the economy recovers in long run), what impact would this new balanced budget rule have on the short run economic performance, i.e. output (Y), price level (P), inflation (∏), nominal interest rate (i) and real interest rate (r)?

Answer 1

1. Consumption need not always equal production but the net capital outflow will tend to equal the trade balance.

2. These capital flows always depend on savings rate and interest rates and thereby adjust to reach the phenomenon of equilibrium.

3. In short term, increased savings rate lead to fall in consumer spending which could lead to recession as consumer spending accounts for more than 75% of the GDP.

4. In the long run, increases savings rate means increased chance of investment for outsourcing eventually increasing the output by higher capital stock and hence concluding higher economic growth.

5. At the time of inflation, government tend to increase rates on savings by triggering it as a tool to come out of the aforesaid phenomenon.