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 $130 billion for every 1 percentage point increase in the real interest rate. Also, suppose that the investment demand curve shifts rightward by $170 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

Answer: Investment declines by $130 billion for every 1 percentage point increase in the real interest rate. Therefore investment will decline by $260 billion for 2 percentage point increase in the real interest rate.

Also, 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.

Therefore net impact will be decline in investment by $70 billion (260-190)

Decline in investment = 260 - 190 = $70 billion.

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