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

Savings are increasing in the economy, which means individuals are putting more money in banks, resulting in a rise in the amount of loanable funds. This will result in increased investment in the economy since businesses will be able to obtain more loans at the present interest rate. This will result in an increase in output and a decrease in the price level. It entails a rise in productivity, which leads to an increase in employment rate.

Step-by-step solution

Aggregate demand :

The entire quantity of products and services sought by customers at a particular price level and period is known as aggregate demand.

Explanation :

Money is either saved or spent. If households elect to save a larger portion of their income, they will spend less and save more.

Because consumption is a component of aggregate demand, any shift in consumption will shift AD. As a result, a drop in consumption will reduce aggregate demand. As a result, the AD curve has shifted to the left. The output level and price level decline as a result of the leftward shift, but the aggregate supply curve remains constant. As a result, the rate of unemployment rises.

In the above diagram, AD curve changed leftward from AD1 to AD2, with price falling from P1 to P2 and Real GDP falling from Y1 to Y2.

Long run aggregate supply curve depicts the new equilibrium as being far away from potential GDP. Because the new equilibrium and potential GDP are so far apart, it leads to a long-term recession and a rise in the cycle unemployment rate.