Question

Consider a closed economy, where the marginal propensity to consume is 0:9. What would be the e§ect on private, public and national saving of a $10 million decrease in both taxes and government spending? Would the equilibrium real interest rate increase, decrease, or stay the same?

Answer 1

Private savings increases with the reduction in taxes. Reduction in government spending means that AD will also reduce. This will also increase private savings. So overall effect will be increase in private savings.

Public savings will be reduced with the reduction in taxes but it will increase with reduction in government spending. So this will nullify the impact of each other on public savings.

National savings is the private + public savings. Increase in private savings will also lead to increase in national savings.

With the increase in saving, supply of loanable funds will increase. This will shift the supply curve to the right. Thus the Equilibrium real interest rate will decrease.