Question

4. Using a simple model of financial markets (supply and demand for loans) speculate what would happen to equilibrium real interest rates, total investment expenditures, and national savings if:

a. The baby boomers started setting aside more of their current income in order to finance their upcoming retirements.

b. U.S. firms wanted to build new production facilities in anticipation of an increase in future sales to the rest of the world.

c. Government expenditures rose and these expenditures were financed by taxes so that the government budget remained balanced (assume that taxes are income taxes, that current consumption depends in part on after tax income, and that the marginal propensity to consume out of disposable income is less than one).

d. Taxes on interest income fall.

Answer 1

Equilibrium real interest rates, Total investment expenditures and national savings are the interrelated concepts which are generally moved along with each other in the cases

a. Lets see the first situation that is the population is going to save their income which will increase the national savings and hence increasing the total investment in the economy which will bring down the equilibrium real interest rates as in general can be said that the demand of interest will be increased.

b. The US firms are willing to expand the businesses and that is why more of the investments are needed which will increase the demand of loans that will increase the equilibrium real interest rates, the reversal effect will be seen on the investment expenditure which will be induced over high interest rates. and hence national savings will be increased.

c. Government expenditure are risen and are linked by the increase in the income taxes. In this case the money is sucked from the economy in the form of taxes that will lead to the reduction in savings and it will further increase the equilibrium rate of interests. This will also decrease the investment expenditure.

d. The taxes on the interest income has fallen. In this case the interest income are directly promoted by reducing the taxes over them. this will induce people to invest more and save more in the form of investments.