8 Use the classical model of a closed economy to predict how

8. Use the classical model of a closed economy to predict how each of the following shocks should affect a nation’s real aggregate income (Y), national saving (S), investment (I), and interest rate (r). Be sure in each case to clearly state your predicted direction of change (up, down, or no change) for all four variables and illustrate your predictions for S, I and r with a supply/demand diagram for the loanable funds market.

The supply of capital (KS) increases

The supply of labor (LS) decreases

Income taxes (T) are reduced

Autonomous investment (i0) increases

Solution

a) As the supply of capital increases the demand for loanable funds decreases. It shifts down.there

b)As the supply of labor decreases, there is no change in supply and demand of loanable funds

c)Income taxes reduces that means people have more money so they will save more and it will lead to increase in the supply of loanable funds. There will be a rightward shift.

d)Autonomous investment increase and so the supply of loanable funds increases. It will shift towards the right.