Question

Model saving as fixed (completely inelastic) like the book does for this problem. Draw diagrams to determine the impact of the following event on the real interest rate. Event: a newly elected Congress cuts government purchases significantly. i. What happens to saving in your diagram? a. shifts right b. shifts left c. no shift ii. What happens to investment in your diagram? a. shifts right b. shifts left c. no shift iii. What happens to the equilibrium real interest rate? a. increase b. decrease c. no change iv. What happens to the equilibrium amount of saving? a. increase b. decrease c. no change iv. What happens to the equilibrium amount of investment? a. increase b. decrease c. no change

Starting with a new diagram do comparative statics like you did above for this event: investment demand decreases due to pessimism about business opportunities. v. What happens to saving in your diagram? a. shifts right b. shifts left c. no shift vi. What happens to investment in your diagram? a. shifts right b. shifts left c. no shift vii. What happens to the equilibrium real interest rate? a. increase b. decrease c. no change viii. What happens to the equilibrium amount of saving? a. increase b. decrease c. no change ix. What happens to the equilibrium amount of investment?

Answer 1

A).

Consider the following fig shows the “national savings” and “investment” of an economy.

Now, “S1” be the initial savings and “i1” be the initial investment of an economy. Now, as the “government spending” increases implied the national savings decreases, => the “national savings” curve will shift to the left to “S2”, => the new equilibrium is “E2” the intersection of “S2” and “I1”. So, the equilibrium real interest rate increases from “i1” to “i2” and equilibrium “savings” as well as “investment” decreases.

So, the correct answers are “B for (i)”, “C for (ii)”, “A for (iii)” and “B and B for (iv)”.   

B).

Now, let’s assume that the investment function decreases implied the investment function will shift to the left side for each “real interest rate”, => the new equilibrium is “E2” intersection of “I2” and “S1”, => the equilibrium real interest rate decreases but the equilibrium savings and investment remain same.

So, the correct answers are “C for (v)”, “B for (vi)”, “B for (vii)”, “C for (viii)” and “C for (ix)”.