1. What determines the amount of output an economy produces?

Factors of production (capital and labor) & level of production technology

2. What determines consumption and investment?

Consumption is determined by the disposable income while investment depends on the real
interest rate

3. Consider an economy described as follows:

Y = C + I + G.
Y = 8,000.
G = 2,500.
T = 2,000.
C = 1,000 + 2/3(Y — T).
I = 1,200 — 100r.
a) In this economy, compute private saving, public saving, and national saving.
Private saving
= (Y – T) – C
= (8,000 – 2,000) – [1,000 + 2/3 (8,000 – 2,000)]
= 6,000 – 5,000
= 1,000

Public saving
=T–G
= 2,000 – 2,500
= -500 (budget deficit)

National saving or National saving

=Y–C–G = private saving + public saving
= 8,000 – 5,000 – 2,500 = 1,000 + (-500)
= 500 = 500

b) Find the equilibrium interest rate.

Equilibrium interest rate:
fund demand = fund supply
investment = saving
I=Y–C–G
I = 500
1200 – 100r = 500
700 = 100r
7% = r
c) Now suppose that G is reduced by 500. Compute private saving, public saving, and
national saving.
Private saving
= (Y – T) – C
= (8,000 – 2,000) – [1,000 + 2/3 (8,000 – 2,000)
= 6,000 – 5,000
= 1,000

Public saving
=T–G
= 2,000 – 2,000
=0

National saving
=Y–C–G
= 8,000 – 5,000 – 2,000
= 1,000

d) Find the new equilibrium interest rate.

I=Y–C–G
I = 1,000
1200 – 100r = 1,000
200 = 100r
2% = r

4. When the government subsidizes investment, such as with an investment tax credit, the
subsidy often applies to only some types of investment. This question asks you to
consider the effect of such a change. Suppose there are two types of investment in the
economy: business investment and residential investment. The interest rate adjusts to
equilibrate national saving and total investment, which is the sum of business
investment and residential investment. Now suppose that the government institutes an
investment tax credit only for business investment.
a) How does this policy affect the demand curve for business investment? The demand
curve for residential investment?

b) Draw the economy’s supply and demand curves for loanable funds. How does this
policy affect the supply and demand for loanable funds? What happens to the
equilibrium interest rate?
c) Compare the old and the new equilibria. How does this policy affect the total
quantity of investment? The quantity of business investment? The quantity of
residential investment?