Question

Suppose Congress (in an attempt to stimulate the economy in both the short and long run) passes an investment-tax credit designed to increase domestic investment.

How will this policy affect (comparing the state of the economy prior to the enactment of the Investment Tax Credit): [Explain how you worked out your answers in each case.]

1) national saving?

2) domestic investment?

3) net capital outflow?

4) the real interest rate?

5) the exchange rate?

6) the trade balance?

Hints:

1) An investment-tax credit provides businesses with a "credit" on their federal income-tax obligation that is proportional to the dollars spent on qualifying capital goods purchases during a given tax year. A 10% tax credit might work as follows. Consider the purchase of a new computer system for your company which costs $100,000. This investment would translate into a $10,000 credit (reduction) in taxes owed by the company at the end of the year. Thus a policy enacting an investment tax credit is expected to increase the demand for investment goods at every interest rate. You should think about what happens to the demand for loanable funds if there is an increase in the domestic demand for investment goods at every real interest rate.

2) Using the 3-graph model developed in chapter 14 (see Figures 3 through 7 on pages 301 - 309), consider first the impact on the demand for loanable funds. If businesses respond as expected to the investment-tax credit, consider what will happen to the demand for loanable funds. Given this, consider what, if any, change there will be in interest rates. If interest rates change, then consider what the expected impact will be on net capital outflow (net foreign investment). [Pay close attention to Figure 3 (page 301). A rise in the real interest rate causes net capital outflow (aka net foreign investment) to move in a negative direction. Think about this in the following way. As real interest rates in the US rise (relative to real rates in the rest of the world) the foreign demand for US assets rises. At the same time the US demand for foreign assets will fall because of the higher return available in the US. Both effects cause net foreign investment to move in a negative direction.]

Answer 1

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, as shown in figure below. 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 declines, since net capital outflow, hence net exports, are 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 decreases.