Question

Consider the closed economy Classical model depicted below, where consumption depends positively on disposable income and negatively on the real interest rate.

1) Suppose the government decides to reduce the overall level of taxes. What happens to public savings (Spublic), private savings (Sprivate), and total savings (S)?.

2) ) According to the Classical model, what are the long-run implications of the above change on the real interest rate (r), output (Y), and the expenditure components of output consumption (C), investment (I), and government expenditure (G))?

Answer 1

Answer 1: when govt reduce the tax, private saving will increase. Disposable income will increase .now people have more to consume. So it will lead to increase in saving ,consumption ,increase in output.

Total saving is the sum of public saving and private saving . When government reduce the taxation . Rate of interest will increase and increase in investment and output but reduce the total saving of an economy.

Answer 2: according to classical model when money supply is constant, and increase in demand for money will increase the real rate of interest . So investment will reduce because people dont want to take loan at higher interest rate. But when government increase the money supply in an economy ,real rate of interest will go down and investment ,output will increase because now people are more attract to higher investment due to low interest rate so output and investment ,consumption of the people will increase.