#189 When the government subsidizes investment

When the government subsidizes investment - Economics

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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.

• How does this policy affect the demand curve for business investment? The demand curve for residential investment?
• 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?
• Compare the old and the new equilibria. How does this policy affect the total quantity of investment? The quantity of business investment?

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Free Chegg Answer

(a) Tax credit to business investment will increase the demand for business investment, shifting demand curve for business investment rightward.

However, demand curve for residential investment will not be affected.

(b) Total demand for Loanable funds comprises demand for business investment and demand for residential investment. So, as demand for business investment rises, total demand for loanable funds rises ceteris paribus. Supply of loanable funds (savings) remaining unchanged, this increases market interest rate.

In following graph, D0 and S0 are initial demand and supply curve for loanable fund, intersecting at point A with equilibrium interest rate r0 and quantity of loanable fund Q0. As demand shifts to D1 intersecting S0 at point B, interest rate rises to r1 and quantity rises to Q1.

(c) Compared to initial equilibrium, in the new equilibrium, interest rate is higher and quantity of loanable funds is higher. Here, while total quantity of investment is higher, the quantity of residential investment is unchanged and quantity of business investment is higher. Increase in total investment is equal to increase in business investment.