Question

Suppose that Congress is considering an investment tax credit, which subsidizes domestic investment.

         a. How does this policy affect national saving, domestic investment, net capital outflow, the interest rate, the exchange rate and the trade balance?

         b. Representatives of several large exports oppose the policy. Why might that be the case?

Answer 1

(a) If Congress passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance also moves toward deficit, because net capital outflow, hence net exports, is lower. The higher real interest rate also increases the quantity of national saving. In summary, saving increases, domestic investment increases, net capital outflow declines, the real interest rate increases, the real exchange rate increases, and the trade balance moves toward deficit.

(b) An appreciation or rise in the real exchange rate reduces exports, make it harder for U.S. exporters to compete in other countries, and easier for other countries to sell goods in the U.S. market, hence the fall in NX implied by the stronger RER.