Comparative Statics

Reading: AB, chapter 4, section 3.

Increase in current income (Y)

Suppose the goods market is initially in equilibrium with r* = 5% with current income at Y₀ as described in the diagram below. Now suppose that current income (Y), which is equivalent to current output, increases from Y₀ to Y₁. This results in a rightward shift of the desired savings graph as depicted below.

At the real interest rate of 5% there is now an excess supply of saving which puts downward pressure on the real interest rate as banks try to create more loans. As r falls, we move along both the desired saving and investment graphs toward the new equilibrium at r = 3%. The end result of the increase in Y is a lower real interest rate and a higher level of both saving and investment.

Increase in the future marginal productivity of capital (FMPK)

Now consider an increase in FMPK due to an increase in business confidence about future profits. This could occur, say, if firms expect that tax laws favoring business may be enacted in the near future. The increase in FMPK leads to a rightward shift up in the desired investment graph holding everything else in the model fixed as illustrated in the graph below.

At r = 5%, desired investment is greater than desired saving so that there is an excess demand for saving. Accordingly, banks are able to raise real interest rates due to the increased demand for loans. As r rises, we move up along both the saving and investment graphs toward the new equilibrium at r = 8%.