Question

An economy is described by the following equations:

C = c₀+ c₁Y_D

Y_D= Y – T

I = b₀+ b₁Y

G = G (autonomous)

T = T (autonomous)

Suppose that consumers decide to consume less (and therefore save more) for any given amount of disposable income. Specifically, assume that consumer confidence (c₁₎falls. What will happen to output, investment, public saving and consumption?

Answer 1

c1 here denotes marginal propensity to consume . So with each dollar rise in disposable income , consumers consume lower fraction of the dollar and save a higher fraction .

Output is GDP = C + I + G ( assuming its a closed economy )

So with fall in c1 , component C falls , hence GDP also falls . When people consume less , there is lack of demand so GDP falls . Investment depends on Y ( output ) . Y depends on YD . So as output falls , investment will also fall . Due to lack of consumer confidence , aggregate demand falls in the economy so investment falls . Private savings rises but public savings are unaffected , since taxes are autonomous and also government expenditure ( G ) . Consumption C falls as mentioned before .