By Sanjay Rode
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Extra info for Advanced Macroeconomics
28) Where, P’s is weighted average of the rest of population’s consumption. This approach explains that utility increases only if the individual’s consumption rises relative to the average. This assumption leads to the result that the individual’s consumption to income (c/y) ratio will depend on his position in the income distribution. A person with an income below the average will tend to have a high c/y ratio because essentially he is trying to keep up to a national average consumption standard with a below average income.
The level of income increases from Y to Y1. But in the long run the reduction in the interest rate and increase in income leads to more investment. The production in the economy increases due to high capital investment. But the high production leads to lower demand, and the prices declines. This is because every firm tries to sell their products in national and international markets. They may sell at lower prices to cover the fixed cost of production. The decline in prices due to competition reduces the profit margin.
In the figure, interest rate increases from I to I1. The increase in income was expected Y1 but income increases up to Y2. The crowding out occurs in the expansionary fiscal policy. It is shown as Y1 to Y2. The increase in interest rate wipes out the increase in total income. Therefore, again at higher level of income and higher interest rate, industrialists do not find it easy to invest money and their investment in firms starts declining. As the investment declines the employment generation in the economy also starts declining.