Question

Suppose government puts a tax on investment at rate τ. That is, you get only 1 − τ apple tree next period if you invest one apple this period. Derive the investment demand equation (analog of Equation 4.1 in Lecture 5). What would be the effect of this tax on net exports and real exchange rate in an open economy in long run and very-long run? Explain in detail by showing the changes in the relevant markets.

Answer 1

A tax on investment disincentivizes an individual to make any investment. The more the tax the lesser the investment.

Here in the question the tax on investment at rate τ. If we get one apple in this period then we get 1 − τ apple tree next period. If we assume that the rate of interest is "r" prevailing in the economy.As I have no access to the 4.1 in lecture 5 I hope that part can be dealt with later by you.

Now the effect of tax on net exports and real exchange rate in an open economy in the long run is

Investment declines in the short run which results in GDP contraction and further affect the aggregate demand. This results in depreciation in the exchange rate as the home currency weakens. But in the very very long run, demand picks up and hence the investment which results in returning back the currency back to normal. Even the consumer anticipates that this tax increase is permanent and hence they shy away from saving. Hence they start to invest which results in the economy coming back to normal.