Question

Suppose the U.S. Congress passes a budget which increases individual income

     taxes by $120 billion and increases infrastructure spending (airports, roads,

     bridges, etc.) by $50 billion. The increase in income taxes is concentrated at the top,

     so the tax increase causes personal consumption expenditures to fall by only $30

     billion. Use this information to answer the questions below. (20 pts)

            a. At constant interest rates (“other things equal”), what would these policy

                 changes do to national saving and domestic investment spending?

                        Change in S =

                        Change in I =

            b. Closed economy analysis: Assuming the U.S. financial system is closed to

                  international financial flows, draw an S/I diagram to illustrate the effect of

                  these policy changes on (1) U.S. interest rates and (2) the quantity of domestic

                  investment spending. Incorporate your numerical answers from part (a) into

                  your diagram.

-3-

            c. Open economy analysis: Now assume that the U.S. financial system is open

                 and that the U.S. is small enough in the global financial system that you can

                 ignore the effect of these policy changes on global interest rates. Draw an S/I

                 diagram to illustrate the effect of the policy changes on (1) U.S. net capital

                 flows and (2) domestic investment spending. When drawing your diagram,

                 assume that the U.S. would have had net capital inflow without the policy

                 changes.

Answer 1