Question

a) Explain how and why an increase in the level of savings affects the long-run growth of real income. b) Explain the role of diminishing returns, and what this implies for relative growth rates across countries. c) Carefully describe and explain one government policy that could increase the long-run growth of real income.

NO HANDWRITING PLEASE! Please provide the explanations and graphs in text/word formate. Thanks in advance.....

Answer 1

Answer:

a)

long run growth rate is:

Y=C+I+G

where Y= total output

C= consumption

G= government expenditure

I= investment

under the classical macroeconomic model we have savings=investment

and savings is positively related to rate of interest.

As rate of interest goes up in a economy the level of savings also goes up.

Hence, a rise in rate of interest raises level of investment.Any investment rise in economy pushes infrastructure and aggregate demand, therefore a saving variation helps to push the aggregate demand curve and affects long run growth of income.

b)

A Diminishing Returns suggests that as an economy continues to increase its human and physical capital, the marginal gain to economic growth will diminish.

For Example: raising the average education level of population by two years from 10th grade to high school diploma(while holding other constant) would produce a certain increase in output.

An additional 2 years of education would increase output further, but marginal gain is much smaller.

Low income countries like china and India tend to have a lower levels of human capital and physical capital, so an investment in capital depending should have a large marginal affect in these countries than in high income countries.

Diminishing returns apply the idea that low income economies could converge to the levels achieved by high income economies.

c)

Fiscal policy can be used as an government policy to raise the long-run growth. An expansionary non-discretionary fiscal policy implies a rise in government expenditure and reduction taxes.

With the help of IS-LM curve, we can show the positive long-run growth due to government policy intervention.

With a rise in government expenditure or reduction in taxes, IS curve shifts from IS0 to IS1.

The initial equilibrium achieved at eo with rate of interest ro and output yo.

After expansionary Fiscal Policy IS shifs from IS0 to IS1 the rate of interest is at r1 with new high output y0.