1. The «Paradox of Thrift» Suppose the closed private economy is...

1. The «Paradox of Thrift»
Suppose the closed private economy is described by the following equations: C = $90 + 0.8YD and
investment function is I =
$50.
(a) Using the functions of each type of expenditures, derive the spending multiplier (in the
common form) and calculate its value for this economy.
(b) Derive the saving function for this economy.
(c) In this economy what are the equilibrium levels:
(i) of output (use two ways of calculations for alternative goods market equilibrium
conditions)
(ii) of consumption spending
(iii) of saving
Draw the graphs in the (AE – Y) and (I,S – Y) spaces.
(Instruction: the graphs must be drawn one under the other)
(d) Suppose households increase their autonomous saving by $10. What would be:
(i) the new consumption function & the new saving function
(ii) the amount of autonomous spending
(iii) the value of the spending multiplier
(iv) the new equilibrium levels:
- of output
- of consumption spending
- of saving
Redraw the graphs from point (c) and show the changes on both graphs.
(e) Now suppose households leave autonomous saving unchanged, but begin to save 25 cents
from each additional dollar of income. What would be:
(i) the new consumption function & the new saving function
(ii) the amount of autonomous spending
(iii) the value of the spending multiplier
(v) the new equilibrium levels:
- of output
- of consumption spending
- of saving
Redraw the graphs from point (c) and show the changes on both graphs.
(f) How the phenomena, described in points (d) and (e), is called? Explain why. What are the
conditions for this phenomenon to take place? Under what conditions can it disappear?
(g) Suppose, firms begin to reinvest part of their profits. Using the new function of the
investment demand, derive the new value of the spending multiplier (in the common form).
(h) Suppose reinvestment in this economy equals to 10% of national income. What will be:
(i) the new function of investment demand for this economy
(ii) the new equilibrium levels:
- of output
- of saving
- of investment spending
Draw the new pair of graphs from point (c) and show the changes on both graphs.
(i) Now suppose that in the situation, described in point (h), autonomous saving increases by
$10. Calculate the new equilibrium levels:
- of output
- of saving
- of investment spending.
What happens to the “paradox of thrift” in the presence of the induced investment? Explain.
Redraw the resulting graphs from point (h) and show the changes.