Question

What forces determine the level of interest rates? Be familiar with the National Saving/ Investment framework we used to model the determination of interest rates. What is crowding-out? What factors increase or decrease savings? What factors increase or decrease investment. Understand the arguments for and against Ricardian equivalence. Use the savings model we have developed to compare the effect on Demand and the real interest rate of deficit-financed tax cuts and government spending increases.

Answer 1

Interest rate is determined by demand and supply of investment , returns on different assets , monetary and fiscal policy , policies abroad ,etc

Due to stimulation of economy , output expands but crowds out due to upward pressure on interest rate.Due to stimulation , interest rate also rises which increases cost of borrowing and thus crowding out private investment..

If interest rate is low investment will increase and vice versa

if interest rate is high , people will tend to save more due to higher oppurunity cost . of holding money and vice versa.

Ricardian equivalce says that consumers are forward looking , tax cut today implies a tax hike tomorrow, leaving consumption unchanged. Hence savings rise , when govt cuts taxes so that forward looking consumers can pay higher taxes in future financed by savings today.