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(Classical theory) Suppose that saving is totally inelastic with respect to the real interest rate. Consumption...

  1. (Classical theory) Suppose that saving is totally inelastic with respect to the real interest rate. Consumption depends on disposable income. (5x3=15)
  1. Discuss the effect of an increase in tax on investment and real interest rate.
  2. What is the effect of an increase in investment demand on saving and real interest rate?
  3. Explain the effect of an equal increase in tax and government expenditure on investment and real interest rate.

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Answer #1

When there is an increase in tax, disposable income reduces. This leads to fall in investment, and a consequent rise in real interest rates to attract more investments.

Increase in investment demand implies higher savings as well, as in equilibrium savings is equal to investment. Also increase in investment demand leads to fall in real interest rates as funds are now easily available.

Increase in tax implies higher revenues for government and thus higher government expenditure. Also, there will be lower investments from private sector and thus real interest rates may rise.

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