ELS Chapter 8: Graphing Exercise Answers
Saving, Investment, and Economic Growth
1. Before working with the applet for this exercise, think about how an increase in technology will affect the demand for and supply of savings. Will a change in technology affect the demand for savings? Will it affect the supply of savings? In what way will it affect the demand or supply of savings?
  answer: An increase in technology helps to make new capital more productive (the marginal product of capital increases) and hence more beneficial for the firm. At any given real interest rate, an increase in the marginal product of capital makes firms more eager to invest (to increase profits), causing the demand for saving (I) curve to shift upward and to the right.
2. What will be the effect of an increase in technology on the real interest rate and the amount of saving and investment in the economy? What happens to the real interest rate, the level of saving, and the level of investment at the new equilibrium? Why? What are the likely long-run economic effects from the increase in technology?
  answer: An increase in technology increases the productivity of capital and increases the demand for saving (an increase in investment), shifting the demand for saving (I) curve to the right. The increase in the demand for saving creates an excess demand for saving at the current real interest rate, causing borrowers to bid up the price of borrowing money, the real interest rate. At the new equilibrium the real interest rate is higher and the level of saving and investment is higher than at the original equilibrium. An increase in capital investment increases labor productivity, increasing output per person. Increases in technology are an important factor in generating economic growth.
3. The U.S. federal budget deficit grew during the early 2000s due to an economic recession, increased homeland security in response to the September 11, 2001 terrorist attacks, a U.S.-led war in Iraq, and tax reduction legislation passed in the spring of 2003. How does an increase in the federal government's budget deficit affect the demand for and supply of savings in the market for savings? Will the increased budget deficit affect the demand for savings? Will it affect the supply of savings? In what way?
  answer: An increase in the federal government's budget deficit reduces the level of public saving, and hence national saving (assuming that private saving does not fall in response to the increase in public saving). This reduction in national saving shifts the saving supply curve to the left.

4.

 What is the effect of an increase in the government's budget deficit on the real interest rate and the amount of saving and investment in the economy? What are the likely long-run economic effects from the increased budget deficit?
  answer: An increase in the government's budget deficit reduces national saving and shifts the supply of savings curve to the left, assuming that households do not increase their private saving enough to compensate for the reduction in government saving. The leftward shift in the supply of saving will increase the equilibrium real interest rate and reduce the overall level of investment and saving in the economy. A reduction in investment in new capital reduces the growth of capital in the economy, reducing the growth of labor productivity and real economic growth. Thus, it is possible that increased budget deficits may lead to lower economic growth in the long run.

5.

 What would be the effect on the real interest rate and the level of investment of government legislation that eliminated income tax on interest earned from savings accounts?
  answer: This type of policy would effectively increase the after-tax rate of return on private saving. Policies that increase the after-tax rate of return on private saving are likely to increase the level of private saving at any given real interest rate, shifting the supply of savings curve to the right. The rightward shift in the S curve reduces the equilibrium real interest rate and increases the level of investment in the economy in the long run.

6.

 What would be the effect on the real interest rate and the level of investment of government legislation that reduced income taxes for firms that invested more money in new capital?
  answer: This type of policy would effectively increase the after-tax rate of return on new capital. Policies that increase the after-tax rate of return on capital are likely to increase the level of investment at any given real interest rate, shifting the demand for savings (I) curve to the right. The rightward shift in the I curve increases the equilibrium real interest rate and increases the level of investment in the economy in the long run.