Question

Explain what happens to saving, investment, and the real interest rate in each of the following scenarios in a closed economy. Illustrate your answer using a saving-investment diagram. Label the axes and curves clearly.

a) Real money supply increases

b) The tax code changes so that business firms face higher tax rates on their revenue (offset by other lump-sum tax changes so there’s no overall change in tax revenue). The rise in taxes reduces desired investment, shifting the Id curve to the left: in equilibrium, this reduce real interest rate, reducing saving as well as investment.

c) Current output rises The rise in output raises desired saving, shifting the Sd curve to the right; in equilibrium, this reduces the real interest rate, increasing investment as well.

d) The average educational level rises, inducing an increase in the future marginal productivity of capital. The rise in future marginal productivity of capital raises desired investment, shifting the Id curve to the right; in equilibrium, this raises the real interest rate, increasing saving as well as investment. 

Answer 1

We assume the economic structure as follows for this analysis.

a) As money supply increases, the Money supply curve moves to the right., there is excess supply in money market and so real rate of interest decreases. This increases the demand for investment so investment demand shifts to the right. The Savings remain unaffected.

b) As tax rate increases, disposable income decrease. So, savings and investments both decrease. This causes a decline in interest rates as well.

c) As the current output increases, the amount of saving increases and the savings curve moves to right. so real onterest rate decrease. Investment remains the same.

d) As MPk increase, the output increases. So, savings increases. Moreover desired investment also increases as less capital is now required.