2018 Macroeconomics FRQ #2
2. Assume the economy of Ucheleand is currently at full employment. The government of Ucheland reduces the tax rate on household interest earnings.
1st you must know what household interest earnings are - interest that people earn on the savings in their bank accounts. If the government reduces the tax on those savings, then people will save more...
(a) What will happen to private savings in Ucheland?
Private savings will increase.
(b) Draw a CLG of the loanable funds market, and show, the effect of the change in private savings identified in (a) on the equilibrium real interest rate.
(c) Given the Real Interest Rate change identified in part (b), answer the following.
(i) What is the short-run effects on aggregate demand? Explain.
If the supply of loanable funds increases, driving the RIR to fall, then citizens will be more likely to take out loans and invest. Investing will shift the AD curve rightward.
(ii) What is the long run effect on the potential real GDP. Explain.
I believe this question is asking about growth in the Long-Run.
Potential GDP is the curve on the PPC. = Any point on the PPC boundary is where resources are Allocatively efficient and referred to as Potential GDP. Potential, as this is the best a society could achieve with all available resources actively engaged.
PPC Cheat Sheet here .
If there is more investment, then we assume that some of this new investment will be investment in capital formation, this new capital creation will push out the PPC boundary = more LR Growth.