Question

Question 4. (6 points each) How would each of the following affects equilibrium saving, investment, and real interest rate? Explain using the saving-investment diagram. State your assumptions if necessary. (1) Income is expected to rise in the future. (2) Productivity is expected to drop next year.

Answer 1

1. If the people expect that their income is going to increase in future, they will increase their current consumption and thus the current saving decrease. The fall in saving rise the equilibrium rate of interest and this will reduce equilibrium quantity of saving and investment. Assumptions. 1. Present interest rate remains constant. 2. Present level of income is constant. 3. Government tax rate on interest earned income remain constant. 4. The tax on income remains constant. si si S Saving and investment With the expectation of rise in future income, the people consume more. Then the supply curve of saving shift to the left from S to S1. The equilibrium real interest rate rise to R1. The equilibrium quantity of saving and investment decrease from S to SI. 2. If the investors expect a fall in productivity in ncar future, they will reduce the present level of capital investment. The investment demand curve shift to the len and the level of investment falls. The equilibrium rate of interest and the equilibrium quantity of saving and investment decrease. Assumptions. 1. Rate of interest remains constant. 2. Marginal efficiency of capital remains constant. 3. No change in government policy. 4. The rate of depreciation remains constant. Rate of interest MIM Investment The expectation of fall in future productivity shift the investment demand curve to the left from 1 to 11. The equilibrium rate of interest falls to R1 and the equilibrium quantity decrease to MI.