Scenario 1: Suppose savers either buy bonds or make deposits in savings accounts

Question

Scenario 1: Suppose savers either buy bonds or make deposits in savings accounts at banks. Initially, the interest income earned on bonds or deposits is taxed at a rate of 20%. Now suppose there is a decrease in the tax rate on interest income, from 20% to 15%.

The following graph shows the market for loanable funds. For each of the given scenarios, adjust the appropriate curve on the graph to help you complete the questions that follow. Treat each scenario separately by resetting the graph to its original state before examining the effect of each individual scenario. (Note: You will not be graded on any changes you make to the graph.) Demand Supply Supply Demand LOANABLE FUNDS (Billions of dollars) Scenario 1: Suppose savers either buy bonds or make deposits in savings accounts at banks. Initially, the interest income earned on bonds or deposits is taxed at a rate of 20%. Now suppose there is a decrease in the tax rate on interest income, from 20% to 15% Shift the appropriate curve on the graph to reflect this change This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds toand the level of investment spending to Scenario 2: 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. Shift the appropriate curve on the graph to reflect this change The repeal of the previously existing tax credit causes the interest rate to and the level of saving to

Explanation / Answer

1. This change in the tax treatment of saving causes equilibrium Interest rate in the market for loanable funds to falls

And the level of investment to increase.

Reason- When tax rate decreases savers will be more willing to save and hence the supply of loanable funds increases. At the same demand level interest rate falls and since interest rate and investment has negative relationship, investment level rises.

2. The repeal of the previously existing tax credit causes the interest rate to fall and the level of savings to fall.

Reason- Since government repeal the investment tax credit , the tax bill again rises . Saving level decreases and interest rate also falls.

3. This change in spending causes the government to run a budget deficit , which decreases national saving.

Reason- Government responds to war and the spending leads to fall in savings. This leads to budget deficit.

This causes the interest rate to rise , crowding out the level of investment spending.

Reason- Since the supply of loanable funds decrease as government spends more on defense . Interest rate rises. And it crowds out the investment spending. As government spends more on defense.

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