Question

c) How would your answer to (b) above change if consumption in Oregon were a negative function of the interest rate. Fpr each of the four variables state: rises more, rises less, rises same, falls less, falls more, falls same, no change, or ambiguous. No computations necessary. In 2-3 sentences explain why this assumption for consumer behavior might be more realistic.

Answer 1

At equilibrium =60+0.6(Y-100+200-1000r +100 = 360 -60+0.6Y - 1000r = 300+0.6Y-1000r or 0.4Y = 300 - 1000r or, Y=750 - 2500r .... (1) Output of the economy is Y=4K1/312/3 = 4(125)" (125) =500 Therefore, from (1) 500 = 750-2500r or, 250 = 2500r ..r=0.1 Therefore, • Investment: I=200-1000(0.1)=100 Consumption: C=60+0.6 (500– 100)=300 Private savings: S=Y-C-T=500-300 - 100 = 100 Real interest rate: r=0.1 = 10% • b) The cut in taxes decreases private savings and increases consumption. The rise in consumption given the output in the economy increases real interest rate. The increase in real interest rate decreases investment in the economy. If the consumption is a negative function of interest rate, then rise in interest rate decreases consumption. Hence, the consumption now rises less than before. This effect decreases private savings less than before, and investment less than before. The assumption of consumption being the negative function of real interest rate is more realistic because, in real life the large part of consumption carries out in credit. Therefore, a rise in interest rate increases price for credit and decreases consumption. Hence, the consumption becomes the negative function of interest rate.