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1)Suppose the government decides to decrease taxes in an effort to increase consumer spending and investment in the economy
1)Suppose the government decides to decrease taxes in an effort to increase consumer spending and investment in the economy.
a. Will this plan succeed in accomplishing both goals?
b. In equilibrium, what happens to interest rates as a result of this action?
c. Would you characterize this as a case of fiscal crowding out? Explain.
3. If the government wants to increase the amount of savings in the economy, how should it alter government spending? What effect will this action have on the interest rate in the economy? (Use the appropriate graph to help demonstrate the effect.)
4. Suppose the production function of a company exhibits increasing returns to scale. Both capital and labor are required for production, and each factor is subject to diminishing marginal productivity.
a. Explain how it is possible for a company to have increasing returns to scale and yet have diminishing marginal productivity for both factors of production.
b. If the firm increases its labor force and keeps the capital stock constant, how will this effect the real wage and the real rental price of capital?
c. If the firm increases both factors by the same percentage, what will be the effect on the real wage and real rental price?
5. Let the following equations characterize an economy: (note the addition of a tax rate on output)
Y = C + I + G
Y = 200
C = 23 + 0.8(Y – T)
I = 50 – 9r
G = 60
T = 40 + 0.1Y
a. Calculate national saving, private saving, and public saving.
b. Determine the equilibrium interest rate.
c. Suppose that output increases to 209. Redo the calculations in (a) and (b). Explain (in terms of savings and investment) the reason for the interest rate change.
d. What caused the change in private savings? Why did public savings change?
Expert Solution
(a)
When government cuts personal income tax, disposable income increases, so consumpption demand increases. When government cuts business income tax, business profitability increases, so firms increase investment demand. Thus, both objectives can be fulfilled.
(b)
Increase in investment shifts the investment demand curve rightward, which increases interest rate. In the IS-LM framework, higher investment and consumption shifts IS curve rightward, which increases interest rate (and increases output).
(c)
When interest rate increases, it dampens investment demand to some extent (magnitude of reduction in investment depends on interest rate sensitivity of investment). As a result, increase in output is lower than the maximum increase in output which was possible without this reduction in investment. This effect is known as crowding-out of private investment.
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