Answer to Question #92190 in Macroeconomics for Dibo angell

Question

Suppose that the government increases tax and government purchases by equall amount what happens to the interests rate and investment in reponse to this balance budget changes

Answer 1

To find what happens to investment if we increase taxes and government spending equally, we use the national income accounts identity. National saving is equal to private plus public saving.

=[Y – T – C(Y – T)] + [T – G]

We should note that Marginal propensity to consume (MPC) multiplied by the change in disposable income, equals the change in consumption as shown below.

∆National saving = [– ∆T – (MPC × (– ∆T))] + [∆T – ∆G]

                             = [– ∆T + (MPC × ∆T)] + 0

                             = (MPC – 1) ∆T.   Remember that ∆T = ∆G.

However, the effect on savings of an equal increment in T and G rest on size of marginal propensity to consume. When MPC is closer to 1 the fall in saving is smaller. For instance, assume MPC is equal to 1, then the decrease in consumption equals the increase in government purchases and the national savings remain unchanged. When the MPC is close to 0 the impact on savings is greater. Therefore, the national savings should fall due to an equal increase in taxes and government spending. The decrease in savings means that a shift to the left by the supply of loanable funds curve. Investment falls and real interest rate rises.