Question

2. Problems and Applications Q2

Suppose that Congress is considering an investment tax credit, which subsidizes domestic investment.

Which of the following accurately describes the effect of an investment tax credit? Check all that apply.

Net capital outflow decreases

Real interest rate increases

National saving increases

Trade balance increases

Exchange rate decreases

Domestic investment decreases

As a result of the investment tax credit, domestic goods will become   expensive for foreigners to purchase.

Answer 1

If Congress passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance also moves toward deficit, because net capital outflow, hence net exports, is lower. The higher real interest rate also increases the quantity of national saving . In short .

Saving increases ,domestic investment increases ,net capital outflow declines

The real interest rate increases, the real exchange rate increases, and the trade balance moves toward deficit Representatives of several large exporters oppose the policy. A rise in the real exchange rate reduces exports, make it harder for U.S. exporters to compete in other countries, and easier for other countries to sell goods in the U.S. market .

That's why as a result of the investment tax credit, domestic goods will become   expensive for foreigners to purchase.