Use a saving-investment diagram to explain what happens to saving, investment, and the real interest rate in each of the following scenarios in a closed economy.(a)In an agricultural economy, great weather this year promises a bumper crop next year, leading citizens to expect higher income next year.(b)Government regulations going into effect next year will reduce the marginal product of capital.(c)The government increases lump-sum taxes on citizens.

What will be an ideal response?

(a)The rise in future income reduces desired saving, shifting the Sd curve to the left; in 
equilibrium, this raises the real interest rate, reducing investment and saving in equilibrium.
(b)The lower future marginal product of capital reduces desired investment, shifting the Id curve 
to the left; in equilibrium, this reduces the real interest rate, reducing saving as well as investment.
(c)If Ricardian Equivalence holds, this has no effect on desired national saving and thus no effect 
in equilibrium on the real interest rate, saving, or investment. If Ricardian Equivalence does not hold, then people may reduce consumption spending somewhat, leading to increased desired national saving, shifting the Sd curve to the right; in equilibrium, this reduces the real interest rate, increasing investment as well as saving.

Economics

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