Question

2. Suppose that your government introduces an investment tax credit, which subsidizes domestic investment. How does this policy affect national saving, domestic investment, net capital outflow, the interest rate, the exchange rate, and the trade balance?
8. Suppose that your countrymen decide to increase their saving. a. If the elasticity of net capital outflow with respect to the real interest rate is very high, will this increase in private saving have large or small effect on domestic investment? b. If the elasticity of exports with respect to the real exchange rate is very low, will this increase in private saving have a large or small effect on your real exchange rate?

Answer 1

2. Investment tax credit will ensure that investment is encouraged and more businesses will invest in new production capacities. This will increase employment which will lead to increase in national savings, domestic investment will also increase, net capital outflow will reduce as corporates would prefer to invest in the domestic economy, the interest rates will slightly increase because of an increase in capital requirement for new businesses, and the exchange rate will be stable as imports would reduce and exports would rise which will lead to narrow trade balance.

8. a. It will have a large effect on domestic investment as capital outflow is high when interest rates in domestic economy are low and vice versa. Thus people will park funds abroad which have higher returns.

b. This means that exports are not much impacted because of the change in real exchange rate. The increase in private saving will have a smaller effect on real exchange rate as even though exports rise because of higher savings and investment they are not impacted because of the real exchange rate, if they were than they would have increased incrementally.