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Ragan/Lipsey 11th edition (Chapter 25)
Question 4
a) Beginning in a long-run equilibrium with Y=Y*, suppose there is an increase in
households’ desired saving (which is equivalent to a decrease in desired consumption). The
AD curve shifts to the left, reducing both real GDP and the price level. The short-run effect
of the increase in desired saving is a decline in the overall level of economic activity and
the creation of a recessionary gap.
b) With Y<Y*, the excess supply in factor markets pushes wages and other factor prices
down, thus reducing firms’ unit costs. The AS curve (eventually) begins to shift down and
to the right, returning real GDP to the unchanged level of potential output (at a lower price
level than in the initial long-run equilibrium).
c) In the long run, after factor prices have fully adjusted, there is no change in real output
since the economy returns to Y*. But there is a change in the composition of output that
may have implications for the future path of potential output.
Comparing the two long-run equilibria, we see that the increase in desired saving
has reduced the price level in the long run. The lower price level has three effects. First, it
increases private-sector wealth and thus increases consumption (partly offsetting the initial
decline in consumption in part (a)). Second, at given values for the exchange rate and
foreign prices, the lower domestic price level increases net exports. The third effect, which
we will explain in detail in Chapter 28 and 29, is that the lower price level causes the
interest rate to fall, thus stimulating domestic investment.
In summary, the new long-run equilibrium has higher NX and I than the initial longrun equilibrium. As we explained in Chapter 22, this implies greater net asset accumulation
and thus greater growth of potential output in the future.