5 Should consumption vary with shortrun output Explain how d

5. Should consumption vary with short-run output?

-Explain how dependence of consumption on actual GDP changes the impact of an AD shock on short-run output in the IS-MP model.

-Explain the multiplier.

Solution

Consumption in the short run varies because we need to consider pronpensity to consume, in short run not all factors of production are readily available so supply cwill also vary . In long run with increase income people save more than consume to earn returns.

IS MP model explain money and investment market , due to AD shock LM shifts upward. The equibilrium interest rate in the economy will be higher, in case of more income people consume more causing downward shift in IS curve . Income , interest rate , consumption falls but investment increases. Investment rises offsetting fall in consumption.

Similarly , the multiplier effect is rise in income due to continous injection of spending by the public. Propensity to spend depends upon consumption and saving in the economy .Suppose banks are required to hold higher percentage of reserves size of multiplier reduces vice-versa.