Using a graph, explain what will happen to investment in Canada if the government reduces the...

Using a graph, explain what will happen to investment in Canada if the government reduces the corporate income tax, and households’ expectation of their future incomes become more uncertain.

Expert Solution

This can be shown using loanable funds model.

If government reduces corporate income tax, firms will increase business investment, which increases demand for loanable funds. Demand curve of loanable funds will shift rightward, increasing interest rate and increasing quantity of loanable funds (saving and investment).

At the same time, household uncertainty over future expectation will increase current savings, increasing supply curve of loanable funds. Supply curve of loanable funds will shift rightward, decreasing interest rate and increasing quantity of loanable funds (saving and investment).

The net effect is a definite increase in quantity of loanable funds (saving and investment), but net effect on interest rate is uncertain.

In following graph, D0 and S0 are initial demand and supply curves of loanable funds, intersecting at point A with initial interest rate r0 and quantity of loanable funds (saving and investment) Q0. Due to higher demand and higher supply, D0 shifts right to D1 and S0 shifts right to S1, intersecting at point B with higher quantity of loanable funds (savings and investment) Q1 and new interest rate r1.

D0 shifts right to D1 and S0 shifts right to S1, intersecting at point B with higher quantity of loanable funds (savings and investment) Q1 and new interest rate r1.

Rahul Sunny answered 1 year ago

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