Question

Consider a Classical model. Suppose there is an increase in sensitivity of private savings to changes in interest rate (i.e. c). How does this impact the effectiveness of taxes to influence the equilibrium interest rate? Assume all parameters are positive.

A. It increases fiscal policy’s effectiveness.

B. It decreases fiscal policy’s effectiveness.

C. It can increase or decrease fiscal policy’s effectiveness depending on other parameter values.

D. It has no effect on fiscal policy’s effectiveness.

Answer 1

Under the classical case when there is an increase in the rate of interest it is considered as the opportunity cost of holding money so private savings are increased and consumption is reduced. Now when there is a fiscal expansion in which government spending is increased or taxes are reduced, there is a simultaneous increase in the rate of interest.

Since the sensitivity of private saving to changes in interest rate is now greater, private savings will now rise by a greater amount and consumption will increase by a lower amount when there is an increase in the disposable income due to government action. Hence it will decrease the fiscal policy's effectiveness since consumption is not rising by the same amount as before.

1. Select option B.