Question

Consider the market for financial capital and the relationship among saving, investment, and the interest rate. Assume that the economy is in a long-run equilibrium with Y=Y*.

1. Suppose there is an increase in consumption in this economy. Briefly explain (in 1 sentence without the use a diagram) any shifts in desired investment or national savings and the resulting impact on national savings, investment and the real interest rate.

2. Suppose the government decides to encourage national saving. Briefly identify (1 sentence) two ways the government could this.

3. Briefly explain (1-2 sentences) the effects of these actions of government (from part b above) on the economic growth rate.

4. Briefly explain (1-2 sentences) what the neoclassicals assume about technology in their model of economic growth and what. It meant for economic growth over time.

   
   

Answer 1

a) With increase in consumption , there will be decrease in savings and taking the impact as a whole the national savings rate will decline .

national savings curve will shift leftwards(showing decline) .

Investment will show contraction along the curve (due to decline in savings) .

The real interest rate will rise .

b) The governement can encourage savings by i) Increasing interest rates

ii) Tax breaks on savings.

c) If the interst rates are increased , it will increase the national savings as people will get higher return on savings but it will raise the cost of borrwing , further decreasing the investment. This may have a negative impact on economic growth as investment is necessary to progress economically.

If tax breaks are given on savings , people will save mpore for future and consume less in present . It will increase economic growrth rate in long run but might have negative effect in short run due to decrease in consumption / Aggregate Demand.

d) Neo - classicals assume technology as an exogenous variable in their economic growth theory . The theory states that technology alongwith labour and capital is one of the main drivers of economic growth and must not be ignored. It is necessary to reach a steady state equilibrium.