Suppose that the investment demand curve in a certain economy is such that inves

Question

Suppose that the investment demand curve in a certain economy is such that investment declines by $120 billion for every 1 percentage point increase in the real interest rate. Also, suppose that the investment demand curve shifts rightward by $190 billion at each real interest rate for every 1 percentage point increase in the expected rate of return from investment. If stimulus spending (an expansionary fiscal policy) by government increases the real interest rate by 2 percentage points, but also raises the expected rate of return on investment by 1 percentage point, how much investment, if any, will be crowded out?

Explanation / Answer

If stimulus spending by government increases the real interest rate by 2 % points , this will reduce investment by ( 2*120) = 240$ billion .

Now it also raises the expected rate of return on investment by 1% point . So this will increase investment by 190$ billion .

Now combining both the results = amount of investment crowded out = ( 240 decrease ) - ( 190 increase )

= 50$ billion

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