Question

9•Chapter 3 – Factors of Production, Profits, MPL, MPK, Real, Cobb-Douglas, GDP expenditure equation, C(Y-T), I(r), MPC, Private Savings, Public Savings, National Savings (S) = I, Effects of Fiscal Policy on interest rates

•Assumptions: Closed, G, T, K, L and therefore Y exogenous

•Same throughout this entire block!

1.If G ↑ (or T ↓) then what happens to interest rates, investment, and savings (do in the right order)? Do with G and T! (Show graph)

Answer 1

When government expenditure increases the IS curve shifts right ward, as a result the equilibrium shifts to E'. The new interest rate is i' and the output is y'. This shows that the interest rate has increased. At higher interest rate investor has little incentive to borrow money from the market and invest hence investment in the market decreases. As the income has increased saving in the market will increase, saving will also increase for the reason that interest rate has increased so keeping money in bank will give higher rate of interest.

Similarly in the case with deduction in taxes the disposable income of the people increases. As a result IS curve shifts towards right. This leads to increase in interest rate. At higher interest rate, people has little incentive to invest. Thus, saving in the economy increases because the rate of return is high and income has also increased.