Change in private saving = change in disposable income–change in consumption Change in consumption = MPC*change in disposable income So∆Sprivate = (-∆T) - ((MPC*(-∆T)) = -∆T - (-∆TMPC) = (1-MPC) *∆T Since Y is fixed, the effect of more government spending would have to be compensated by an equal amount of decrease in another category of demand. Holding Consumption constant, increase in government purchases should automatically decrease the National Saving (as we saw in the previous problem) and decrease the amount of investment (I). This effect of tax increase will largely depend of the MPC. The immediate effect of tax increase is the decrease in the amount of disposable income and consequent decrease in spending by∆T. Consumption decreases in the amount of∆T*MPC. The higher the MPC, the greater the effect of the tax increase on consumption.If my MPC is high then the tax increase wouldn’t really affect savings because I don’t have a propensity to save anyway. If my MPC is less than 0, meaning my MPS is higher than imposition of higher tax would negatively affect my savings and the Investment would be reduced by the same amount. If we assume then that marginal propensity to save is relatively high then the tax increase will only exacerbate the negative effect of increased government spending on national saving and the total amount available to invest will be greatly reduced. In both cases the policies reduce national savings, supply of loanable funds curve shifts to the left. In conclusion investment will fall in response to a balanced budget increase in government spending. Graphically the shift would look as follows: I, SI(r) S1 S2r 1 r 2
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