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The increase in real income mo vates households to

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Unformatted text preview: tal services clears, the real rental price R/P=MPK. Therefore, i = MPK (evaluated at given K and L) − δ 6 ConsumpEon, saving, and investment Aggregate household budget constraint  ­ Given that the markets for bonds, labour, and capital services clear, C + ∆K = Y − δK C + ∆K = A F( K, L) − δK  ­  An increase in A raises real GDP for given K and L, we see that a rise in A raises overall real income (RHS).  ­  The increase in real income mo-vates households to raise current (as well as future consump-on)  ­ income effect, which works against the intertemporal subs-tu-on effects which tends to reduce current consump-on. 7 •  •  •  The increase in the interest rate tends to reduce current consump-on (intertemporal ­subsHtuHon effect). The net change in current consump-on depends on whether the income effect is stronger or weaker than the intertemporal ­subs-tu-on effect. We can sharpen our predic-on because the size of the income effect depends on how long the change in the technology level lasts. 8 Assume that the change in A is permanent. •  The increases in real income tend also to be permanent. •  The propensity to consume out of higher income, ΔC/ΔY, would be close to one. •  When the increase in A is permanent, current consump-on will rise. However, as long as the intertemporal ­subs-tu-on operates at all, the increase in current consump-on will be less than the increase in real GDP. •  Current consump-on, C, rises, but by less than the increase in real income (GDP) Y. Therefore, household must rise on the LHS (hence, net investment, ∆K, must increase)  ­ the increase in real GDP shows up partly as more C and partl...
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