dolution

 

1. The diagram below shows the economy’s capital market, with the initial equilibrium at point E, with an interest rate of i∗ and investment (and saving) equal to I ∗.

 

               

 

a. Suppose the government introduces a program of tax credits to firms that increase their desired investment in new physical capital. What is the effect on the equilibrium interest rate, investment, and saving of this policy? Show the effect of this policy in the diagram.

 

b. In part (a), the policy has led to a higher interest rate higher investment by firms. Does this contradict our discussion in this chapter about how firms’ desired investment is negatively related to the interest rate? Explain.

 

c. Now suppose the government introduces a program of tax credits to households who save. What is the effect on the equilibrium interest rate, investment, and saving of this policy? Show the effect of this policy in the diagram.

 

d. In part (c), the policy has led to a lower interest rate and higher saving by households. Does this contradict our discussion in this chapter about how households’ desired

saving is positively related to the interest rate? Explain