Question

Suppose the federal government is concerned about long-run economic growth. Suppose many lawmakers watched Robert Gordon's TED talk and are worried that the U.S. will not experience significant gains in productivity in the future. To combat this, the government enacts a tax credit to encourage firms to develop new technologies that can increase labor productivity. What this means is that if firms undertake large research and development projects the government will reimburse them for some of their expenses. At the same time, the government makes interest earned on savings tax exempt. Instead of having to pay income taxes on interest earned on savings accounts, interest income is now tax free.

Using the market for loanable funds illustrate the impact that these two new policies will have on the real interest rate and the level of savings and investment in the macroeconomy. In addition, please explain why you shifted any curves that you did.

Answer 1

The goverment enacts the tax credit. This induces firms to invest in newer research and technology and since they are reimbursed for some of the investments that they do, the firms are encouraged to invest more (as they are saving money on newer investments). This will shift the investment curve upwards.

Next when at the same time the goverment makes interest earned on savings tax exempt, the savers can save more money as they do not have tp pay taxes on their savings. This will again shift the savings curve upwards.

See the attached image for the effect on savings and real interest rate.

In the graph I have marked two points e' and e''. e' is the higher interest rate which would have occured if only invetments had increased while e'' is a lower interest rate which would have prevailed if only savings rate had increased. Since the goverment implemented both policies at the same time, the two oppositte changes cancel each other out and thus there is no change in real interest rate.