ANALYTICAL PROBLEMS

1. Use the saving-investment diagram to analyze the effects of the following on national saving, investment, and the real interest rate. Explain your reasoning.

a. Consumers become more future-oriented and thus decide to save more.

b. The government announces a large, one-time bonus payment to veterans returning from a war. The bonus will be financed by additional taxes levied on the general population over the next five years.

c. The government introduces an investment tax credit (offset by other types of taxes, so total tax collections remain unchanged).

d. A large number of accessible oil deposits are dis­covered, which increases the expected future mar­ginal product of oil rigs and pipelines. It also causes an increase in expected future income.

2. A country loses much of its capital stock to a war.

a. What effects should this event have on the coun­try's current employment, output, and real wage?

b. What effect will the loss of capital have on desired investment?

c. Assume that the desired saving function doesn't change. What effect does the loss of capital have on the country's real interest rate and the quantity of investment?

3. a. Analyze the effects of a temporary increase in the

price of oil (a temporary adverse supply shock) on current output, employment, the real wage, national saving, investment, and the real interest rate. Because the supply shock is temporary, you should assume that the expected future MPK and households' expected future incomes are unchanged. Assume throughout that output and employment remain at full-employment levels (which may change).

b. Analyze the effects of a permanent increase in the price of oil (a permanent adverse supply shock) on current output, employment, the real wage, national saving, investment, and the real interest rate. Show that in this case, unlike the case of a temporary supply shock, the real interest rate need not change.

4. Economists often argue that a temporary increase in government purchases—say, for military purposes— will crowd out private investment. Use the saving­investment diagram to illustrate this point, explaining why the curve(s) shift. Does it matter whether the temporary increase in military spending is funded by taxes or by borrowing?

Alternatively, suppose that the temporary increase in government purchases is for infrastructure (roads, sewers, bridges) rather than for military purposes. The government spending on infrastructure makes private investment more productive, increasing the expected future MPK at each level of the capital stock. Use the saving-investment diagram to analyze the effects of government infrastructure spending on current con­sumption, national saving, investment, and the real interest rate. Does investment by private firms get crowded out by this kind of government investment? If not, what kind of spending, if any, does get crowded out? Assume that there is no change in current produc­tivity or current output and assume (for simplicity) that households do not expect a change in their future incomes.

5. “A permanent increase in government purchases has a larger effect than a temporary increase of the same amount." Use the saving-investment diagram to evaluate this statement, focusing on effects on con­sumption, investment, and the real interest rate for a fixed level of output. (Hint: The permanent increase in government purchases implies larger increases in current and future taxes.)

6. (Appendix 4.A) Draw a budget line and indifference curves for a consumer who initially is a borrower. Be sure to indicate the no-borrowing, no-lending point and the optimal consumption point.

7. (Appendix 4.A) Consumers typically pay a higher real interest rate to borrow than they receive when they lend (by making bank deposits, for example). Draw a consumer's budget line under the assump­tion that the real interest rate earned on funds lent, r_l is lower than the real interest rate paid to borrow, r_b. Show how the budget line is affected by an increase in r_l, an increase in r_b, or an increase in the consum­er's initial wealth.

Show that changes in r_l and r_b may leave current and future consumption unchanged. (Hint: Draw the consumer's indifference curves so that the consumer initially chooses the no-borrowing, no-lending point.)

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