Question

Individual Retirement Accounts (IRAs) allow people to shelter some of their income from taxation. Suppose the maximum annual contribution to such accounts is $5,000 per person. Now suppose there is an increase in the maximum contribution, from $5,000 to $8,000 per year.

(a) This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to ______ and the level of investment spending to _______.
(b) An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the government repeals a previously existing investment tax credit.
The repeal of the previously existing tax credit causes the interest rate to ______ and the level of investment to _______.
(c) Initially, the government's budget is balanced, then the government responds to the conclusion of a war by significantly reducing defense spending without changing taxes.
(d) This change in spending causes the government to run a budget _______, which _______ national saving.
(e) This causes the interest rate to _______, and the level of investment spending to _______

Answer 1

(a) This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to DECREASE and the level of investment spending to INCREASE.

The supply of loanable funds will increase, therefore, the equilibrium price (interest rate) will decrease.

(b) An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the government repeals a previously existing investment tax credit.

The repeal of the previously existing tax credit causes the interest rate to DECREASE and the level of investment to DECREASE.

The demand of loanable will decrease, therefore, decreasing the equilibrium price (interest rate).

(c) Initially, the government's budget is balanced, then the government responds to the conclusion of a war by significantly reducing defense spending without changing taxes.

(d) This change in spending causes the government to run a budget SURPLUS, which INCREASES national saving.

(e) This causes the interest rate to DECREASE, and the level of investment spending to INCREASE.

Since the government has extra money, it can use it to pay existing debts or finance themselves without having to issue new debt. Since the demand for loanable funds decrease, the interest rates will fall.