Consider a Keynesian economy with the following features: » Investment function:

Question

Consider a Keynesian economy with the following features: » Investment function: I -20- 217- 22T Note: is a lump-sum tax on investment How does an increase in the investment sensitivity to interest rate impact the effectiveness of taxes to influence output? Note: Assume that the investment tax does not affect net tax receipts or net capital stock. A. it increases fiscal policy's effectiveness. B. it decreases fiscal policv's effectiveness. C. it can increase or decrease fiscal policy's effectiveness depending on other paranm eter values. D. it has no effect on fiscal policy's effectiveness.

Explanation / Answer

ans : option D

reason: suppose as part of the fiscal policy gov. reduces taxes that means IS curve will shift to right , thus increasing interest rates and output ; but , as a result of increase in interest rate and high sensitivity of the investment to interest rates , investment falls by a large amount and also because of fallinf taxes investment rises as I = f(r,T), thus both effect cancels out each other

. thus, we see interest rate sensitivity has no effect on the effectivness of fiscal policy .

on the other hand,suppose, taxes rises that implies IS curve will shift to left and hence, interest rate and output both falls ; but as a result of fall in interest rate and high sensitivity of investment to interest rate , investment rises by a large amount , but rise in tax leads to opposite effect of fall in investment as I = f(r.T) and hence, we say interest rate sensitivity of investment has no effect on the effectivness of fiscal policy.

thus, we see interest rate sensitivity has no effect on fiscal policy effectiveness as long as I = f(r,T)

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