Suppose consumers in the economy suddenly become more pessimistic about the future, which leads them to save more. Use − diagram to answer the following questions. (a) (10 points) Describe the short-run effects on output, interest rate, price level, consumption, investment, and real money balances. (b) (10 points) Suppose in the short run, the shock shifts the curve horizontally by 1, 000, and the current marginal propensity to consume is 0.2. Is the short-run change in output less than, equal to, or greater than 1, 000? If the government wants to adjust taxes to keep the output at its initial level, should it increase or decrease taxes and by how much? (c) (10 points) Suppose that a new Federal Reserve chair is announced. The new chair could be Mrs Hawk, who has a reputation for being intolerant of inflation, or Mr Dove, who doesn’t have a keen interest in reducing inflation. In which case would the appointment of a new chair stabilize output after the shock in consumers’ marginal propensity to save? Note that the chair hasn’t carried out any monetary policy yet. (Hint: consider expected inflation.)
