Question

The model of the market for loanable funds shows that an investment tax credit will cause interest rates and investment to rise. Yet our model of how investors behave claims that higher interest rates lead to lower in-vestment. How can these two opposing statements be reconciled?

Answer 1

An Investment tax credit can be defined as an amount that firms are allowed by law to deduct from their taxes, and it shows an amount they reinvest in themselves. It is given to encourage economic growth.

So in the loanable fund market, when the interest rate increases, even then the firms borrow funds from the market for investment because this amount will be deducted from the tax payment due to the firms. So the demand for loanable fund increases, hence the equilibrium interest rate also increases but the demand for fund also increases. This is due to investment tax credit facility.

Yet our model of how investors behave claims that higher interest rates lead to lower investment. This is true but in the case of without investment tax credit but when investment tax credit facility is available the cost of high-interest rate is compensated by the investment tax credit. So it is better for the firms to take more loans and invest more and earn maximum profits.

Hence this two contradictory statement can be reconciled in the above-described manners.