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 $150 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

Ans:$50 billion

Explanation: Suppose that the investment demand curve in a certain economy is such that investment declines by $100 billion for every 1 percentage point increase in the real interest rate. Also, suppose that the investment demand curve shifts rightward by $150 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? If stimulus spending (an expansionary fiscal policy) by government increases the real interest rate by 2 percentage points this will reduce investment by $200 billion. If stimulus spending (an expansionary fiscal policy) also raises the expected rate of return on investment by 1 percentage point this increases investment by $150 billion Combining these two effects results in $50 billion in investment spending being crowded out by the expansionary fiscal policy (= $200 (decrease from interest rate movement) - $150 (increase from the expected rate of return increase)).

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