Question

Describe how each of the following developments will affect the economy’s normal real interest rate and normal investment.

a. The government institutes a permanent investment tax credit (ITC). (You can think of an ITC as a program that reduces the effective purchase price of new capital for firms.)

b. Increasing risk aversion causes American consumers as a group to permanently consume less at every level of the real interest rate.

Answer 1

a)

A Permanent investment tax credit would reduce the effective price of new capital for firms. It will reduce the cost of initiating new businesses. Hence, investment demand would rise and it would further cause rise in output and employment.

Rise in demand for investment or pick up in investment activities would cause demand for money to rise. Increased demand for money will lead to rise in interest rate in market.

b)

Fall in consumption implies the fall in aggregate demand in economy. it would further lessen expected profits. Thus, overall investment activities face fall. Fall in investment activities will reduce demand for money. Thus interest rate also would fall.