Under less-than-full-employment conditions, an increase in the desired level of domestic consumption will
1. increase the equilibrium level of output and employment and reduce the equilibrium current account balance.
2. increase the equilibrium levels of output employment and the current account balance.
3. reduce the equilibrium levels of output and employment and the current account balance.
4. affect the current account balance in a direction that can only be determined from additional information about the shocks to imports and savings.
Choose the correct option.
The correct choice is option 1. The increase in desired consumption reduces the desired level of savings. This shifts the NL line to the left, raising the equilibrium level of income and employment and reducing the equilibrium current account balance. Another way of visualizing this is to note that the increase in desired consumption increases the aggregate demand for domestic output. Employment and output increase in response. The increase in the equilibrium level of income increases imports, reducing the equilibrium current account surplus (or increasing the deficit). One might imagine that the increase in desired consumption might be associated with an increase in desired imports. If so, this would shift the CA line to the left, further reducing the equilibrium current account balance.
The reduction in desired savings reduces the desired net capital outflow (savings minus investment) which shifts the NL line to the left. Given an unchanged CA line, this will lead to a rise in equilibrium output and employment and a fall in the equilibrium current account balance. If the increase in desired consumption is accompanied by an increase in desired imports the CA line will also shift to the left. This will further reduce the equilibrium current account balance and moderate the increase in income and employment.
Is it possible that the CA line could shift so far to the left that equilibrium output will fall? If all of the reduction in consumption went against imports the increase in desired imports would exactly equal the reduction in desired savings and the NL and CA lines would shift to the left by the same amount. In this unrealistic and most extreme possible scenario the equilibrium current account balance would fall without any change in equilibrium output. The direction of effect on the equilibrium current account balance is unambiguous, however, which is why option option 4 is an incorrect choice.