Question

Suppose there is a spell of excellent weather that increases income and at the same time there is an increase in the tax rate on capital income. As a result of these shocks,

A	the equilibrium interest rate and equilibrium savings may fall, rise, or stay the same

B	equilibrium savings will definitely rise, but the equilibrium interest rate may rise, fall, or stay the same

C	the equilibrium interest rate will definitely fall, but equilibrium investment may fall, rise, or stay the same

D	the equilibrium interest rate will fall and equilibrium savings will also fall

Answer 1

Option (A).

Higher income will increase savings, shifting the savings curve rightward, increasing quantity of savings and decreasing interest rate. But higher tax rate on capital gains will decrease investment, shifting the investment curve leftward, decreasing quantity of savings and increasing interest rate. The forces being opposite, the net effect may be a rise, fall or no change of savings, and a rise, fall or no change in interest rate. The final outcome depends on magnitude of shift in the two curves.