2002B AP Macro Exam (Form B) Question 2
This one hurts.
Watch me answer it here
(a) What is the effect of the change in tax policy on each of the following?
(i) Consumption
(ii) National Savings
Consumption would naturally decrease as the price of things are increased. If consumption decreases and citizens can either spend or save then if spending decreases savings must increase. National savings increases.
I like the College Boards answer better than my own.
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Answer - Income becomes savings and consumption, so to tax income is effectively to tax both savings and
consumption. If the government replaces the income tax with a national sales tax, only consumption will be
taxed, and saving will become more attractive. Thus, consumption will decrease and national saving will
increase.
(b) Using a CLG of the loanable funds market, explain how the change in tax policy will affect each of the following.
(i) Real interest rate
(ii) Investment
If national savings has increased then the supply of loanable funds must increase lowering the Real Interest Rate (RIR) decreases. If the RIR decreases then we should expect Investment (I) to increase.
Answer - As indicated in the graph above, an increase in saving will shift the supply of loanable funds to the right,
thereby decreasing the real interest rate. Investment responds positively to a decrease in the real interest rate.
(c) Explain how this change in policy will affect long-run economic growth.
If RIR decrease then we should expect an increase in Investment which implies that there will be more capital formation (more equipment, technology) - Long run economic growth will increase as capital formation.
Answer - In the long run economic growth will increase, because the decrease in the interest rate will increase
investment, which increases the capital stock and boosts productivity.
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