Question

Using the model of long-run income determination developed in Chapter 3, explain how the following changes affect the real interest rate, investment, consumption, and government expenditure. Include the appropriate diagram as part of your answer in each case.

(a) The government increases government purchases.

(b) The government increases taxes and government purchases by identical amounts (i.e. new expen- ditures are paid for with new taxes). Does your answer depend on the marginal propensity to consume? Explain.

(c) Expectations about the future profitability of investment improve. (Hint: For a given real interest rate, r, firms will invest a greater amount after expectations improve).

Answer 1

"Consider the given problem here the goods market eqn condition is given below C (V - T) + I (r) + G = V implies I (r) = Y - C - C = (Y - T) - C + (T - G) We can see that 'r' be the real rate of interest and I = investment Now the RHS = National saving totally independent of ""r"" Consider the given fig where the downward stepping curve show the investment curve which is negatively related to ""r"" Initially E_1 be the eqn where the eqn r = r_1 & J = S_1 Now an govt increases its expenditure implies the national saving will reduce to S_2 from S_1 implies a new eqn will established at E_2 where I = I_2 < I_1 r = r_1 > r_1 implies So as the govt increases its expenditure leads to increase in ""x"" & ""6"" but I will fall down on"