Question

Suppose the government changed the tax laws with the result with the result that people were encouraged to consume more and save less. Using the loanablefunds model a consequence would be ____ interest rates and ____investments.

a.)lower, lower
B.)lower, higher
C.)higher, lower
D.)higher, higher

Answer 1

A government policy that encourages consumption and discourages savings would lead to higher interest rates and potentially higher investments, depending on the confidence of businesses in the economy and the elasticity of the supply of financial capital.

Step-by-step explanation:

If the government changes tax laws to encourage consumption over savings, using the loanable funds model, this would typically result in higher interest rates and, consequently, higher investments. Such policies would reduce the incentive for individuals to save by decreasing the returns on savings. According to the loanable funds model, when savings decrease, the supply of loanable funds contracts, leading to an increase in the interest rates.

In this dynamic, with higher interest rates, borrowing becomes more expensive, and this can sometimes lead to increased investment if those who are borrowing anticipate higher returns from their investments than the higher cost of borrowing. Therefore, if businesses and entrepreneurs are confident in the economy and expect high returns, they will be more likely to borrow even at higher interest rates. This results in an increase in investing activities.

However, the impact on savings and investment can also depend on the elasticity of the supply curve for financial capital. If the supply is elastic, savings levels can change significantly with the interest rates, influencing the amount of funds available for investment. Conversely, if it is inelastic, savings will not significantly increase even if interest rates rise.