Question

If households decide to save a larger portion of their income, what effect would this have on the output, employment, and price level in the short run? What about the long run?

Short answer

In the short run, households deciding to save a larger portion of their income will lead to a decrease in consumption, causing a leftward shift in the aggregate demand curve. This results in a lower output, reduced employment, and decreased price levels. However, in the long run, the economy adjusts to the new level of aggregate demand with the short-run aggregate supply curve shifting rightward. This brings output back to its potential level, increases employment, and results in a lower price level compared to the short run.

Step-by-step solution

Understanding the situation

Let's start by understanding the situation. When households decide to save more, it implies that they reduce their consumption expenditure. This decrease in consumption affects the aggregate demand in the economy.

Analyzing the short run effects

In the short run, we can analyze the effects on output, employment, and price level using the aggregate demand and supply model. The aggregate demand (AD) curve is downward sloping, while the short-run aggregate supply (SRAS) curve is upward sloping. The intersection of these two curves determines the equilibrium output, employment, and price level.

Decrease in Aggregate Demand

When households save more and reduce consumption, aggregate demand decreases. This will lead to a leftward shift in the AD curve. In the short run, since the SRAS curve remains unchanged, the new AD curve will intersect the SRAS curve at a lower output and price level. As shown in the graph below: \[AD_1 -> AD_2\] \[Y_1 -> Y_2\] \[P_1 -> P_2\] Where: - \(AD_1\) = initial aggregate demand - \(AD_2\) = new aggregate demand - \(Y_1\) = initial output - \(Y_2\) = new output - \(P_1\) = initial price level - \(P_2\) = new price level As the output decreases, employment also decreases due to lower production.

Long run effects

In the long run, the economy will adjust to the new level of aggregate demand. The long-run aggregate supply (LRAS) curve is vertical, which implies that the price level does not affect the output. If there are unemployment and unused resources, businesses will lower their prices, and wages to compete for the fewer customers and the SRAS curve will shift rightward. As the SRAS curve shifts, the new equilibrium is reached where the AD curve intersects both the SRAS and LRAS curve. This means that in the long run, output will return to its potential level, employment will increase, and the price level will be lower compared to the short-run outcome. This can be seen in the graph below: \[SRAS_2 > SRAS_1\] \[Y_LR = Y_1\] \[P_LR<P_2\] Where: - \(SRAS_1\) = initial short-run aggregate supply - \(SRAS_2\) = new short-run aggregate supply - \(Y_LR\) = long-run output - \(P_LR\) = long-run price level In conclusion, an increase in households savings will have negative implications on output, employment, and prices in the short run. In the long run, the economy adjusts to the new level of aggregate demand, with output returning to its potential level and the price level being lower than in the short run.