Question

1. Within the classical framework, explain the effects of a decline in expected profitability on investment. 2. If the government decides to tighten spending by buying bonds, what are the implications for aggregate demand in the classical case? How does this differ if the government chooses to reduce spending by controlling the printing of money? 3. Within the classical model, analyze the effects of an increase in (a) lump-sum taxes; (b) marginal income tax rate. Consider effects on real output, the price level and the rate of interest. Consider cases when the increased revenue produced by the tax increase results in a decline in bond sales to the public and when it results in lower money creation.

Answer 1

Answer:

1.

the effects of a decline in expected profitability on investment are:

In Classical framework all the three concepts of aggregate domestic expenditure — consump­tion investment and government expenditure — plays an explicit role in determining the equilibrium of interest rate.

In the classical framework, business investment was a function of expected profitability of investment and the rate of interest. Expected profitability was assumed to vary with expectations of demand over entire economic lives. And these expectations were subjected to shifts in the expected profitability of investment .

If expected profitability remained unchanged then the investment expenditures varied inversely with the high rate of interest. And business supply of bonds equaled to the level of investment expenditure.

Role of the Interest Rate in establishings the investments:

The rate of interest acts as a stabilizer in the classical model framework. If due to an exogenous event business people lower their expectations about future profits from investment then they will reduce their invest­ment levels which would lead to the fall in the demand for loanable funds.

Let take a situation where the government budget is balanced (G = T), private investment will be the only source to demand for loanable funds. Now if due to a fall in expected profitability of investment the investment demand schedule shifts to the left from I0 to I1, investment will fall by change in I at the same rate of interest.

So there will be an excess supply of the loanable funds at an original rate of interest which will cause the rate of interest to fall from I0 to I1.

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investment increases by change in I due to the fall in the rate of interest. New equilibrium occurs at the interest rate with the saving of supply of loanable funds again equal to investment of the demand for loanable funds.

At new equilibrium point E” the increase in consumption that is fall in saving plus the increase in investment caused by the drop in interest rate. Since interest rate falls, the sum of the private sector demands (C + I) remains unchanged even if there is an autonomous decline in investment demand.

2.

the implications for aggregate demand in the classical case and this differ if the government chooses to reduce  spending by controIling the printing of money:

When the government buys bonds it infuses money into the economy.

Due to increased demand for the bonds the prices of bonds rise thereby reducing the interest rates.

Since, money is infused in the economy the consumption and investment expenditure increases leading to increase in the aggregate demand and giving rise to increase in general price level or inflation.

Because of increased aggregate demand the aggregate supply also increases and hence, a new equilibrium is achieved.

In case of reduction in money printing the money supply reduces and there is decrease in the government spending leading to fall in the aggregate demand causing the price level to fall.

Hence, the price level and output decrease.

3.

effects of an increase in

(a) lump-sum taxes

(b) marginal income tax rate are:

An increase in marginal income tax will decrease the disposable income and it will result in fall in consumption.

As aggregate demand fall, employment also falls, interest rate decreases.

With this low-interest-rate government start to buy the government bond. By this effect, interest rate decreases and consumers start to consume more.

So decrease in consumption by the rise in marginal tax offsets by some extent with increase in buying bonds.

For crowding out effect consumption, employment does not fall entirely.

Price does not rise entirely by this crowding out effect.

At first IS curve shift from IS1 to IS2 to by the effect of an increase in marginal tax.

Then by crowding out effect, it rises to IS3. and employment and output decrease to Y3 instead of Y2.

By tax increase government's revenue increases.

And it will result in buying government bond and more money creates in the economy.