Question

In our construction of the savings and investment model, we considered government spending to be immediate spending. In other words, there was no “investment” component to government spending. Let’s change up that assumption. Suppose government spending comes in two types: investment spending (new airports, for example) as well as government consumption (snow plowing, for example). Call the first GI and the second GCE.

a. Derive the savings and investment equations under this new assumption and prove, once again, that in equilibrium, savings equals investment

. b. Draw the savings and investment functions on a chart of the market for loanable funds.

c.Show on the chart you just drew what difference it makes if the government increases its deficit to increase investment rather than government consumption.

Answer 1

Part A---

Let us define the variables first: Y= income, S= savings, I= investment, G= government spending

GDP= Y ( let us consider a closed economy with no imports or exports)

(1). Y= C+I+G

(2). I =Y - C - G

Now let us create and equation for Savings(S):

Savings can be calculated by Y - G(government purchases/spending) - Consumption(C)

Thus, (3). S= Y - G - C

Now we substitute the first equation(1) in (3). This gives---

(4) S= (C + I + G) - G - C

C and C, G and G cancel each other out leaving S=I

Savings = Investment

Hence proved.

Part (B)

Part C: