Question

Suppose the government provides new tax incentives to encourage investment. Use the appropriate diagrams to determine how this policy would affect: a. the real interest rate b. net capital outflow c. the real exchange rate d. net exports

Answer 1

Implementation of tax incentive is an expansionary fiscal policy by the authority.
Real interest rate:

In the figure, the x axis shows the output level and price level in the y axis. AD is aggregate demand curve and AS is the aggregate supply. LRAS is the long run aggregate supply curve. Due to some tax incentives the demand curve will shift right to AD’. Then the price level increased; on the other hand the real interest rate fall down and enhance the investment level and total output.
Net capital outflow: The falling down of interest rate increase the investment level; at the same time the capital outflow increased. Capital outflow
Real interest rate: If the tax incentives introduced the interest rate fall down and the domestic currency rate fall down. Thus the real exchange rate reduced.
Net export: When the tax incentives occurred the currency value fall down. It leads to the increasing rate in export and all. The dynamics of change is, when tax rate incentives leads to fall in interest rate. This reduction leads to increase in the level of investment. This enhances the national income and overall production. Through the fall down of interest rate the domestic currency depreciates. Then the export rate increased.