Question

Please judge the statement: “a change in tax laws that encouraged greater saving would lower interest rates.” The answer is correct.

But I wonder why. Doesn’t a high interest rate standard better motivate people to put their money in banks or financial assets? And these are all “savings”.

Please explain. Thank you very much!

Answer 1

Suppose the government presents tax incentives to raise savings. For example, taxes on interest earned on investments could be reduced or eliminated. The increased saving tax benefits would encourage more people to lower their current levels of consumption and increase their savings. This will result in an increase in the supply of loanable funds (shift to the right). As the interest rate drops, there will be a greater incentive for people and companies to borrow, going along the demand curve to boost the market's balance of borrowing and lending.

Suppose the government starts spending more, leading to an increase in the government budget deficit. The increase in government spending would minimize "public savings." "State Saving" is equivalent to all of a country's savings. It covers all of the "PrivateSaving" that occurs when people consume less than their revenue and all of the "Government Saving" which happens when the government collects more money than it spends. The fall in Public Saving would trigger the reduction in National Saving, the supply of loanable funds will decrease, and interest rates will increase. Higher interest rates will deter private lending and will continue to "crowd out" any private investment in equity.