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Consider the goods market equilibrium model (the saving-investment diagram). When the government increases its spending temporarily,...

Consider the goods market equilibrium model (the saving-investment diagram). When the government increases its spending temporarily, what would happen to the real interest rate and national saving in equilibrium? Explain using the saving-investment diagram.

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Answer #1

Increase in government spending increases government borrowing, which in turn increases investment. The investment function shifts rightward, increasing both interest rate and national saving (investment).

In following graph, S0 and I0 are initial saving and investment curves intersecting at point A with initial interest rate r0 and quantity of national saving (investment) Q0. Higher government borrowing shifts I0 rightward to I1, intersecting S0 at point B with higher interest rate r1 and higher quantity of national saving (investment) Q1.

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