You are working at an investment firm that has many investments in Lithuania. You have been asked to do a simple simulation showing the potential effects of Lithuania building a high-speed rail network, and what will happen if there is worldwide pressure on interest rates. All amounts are in millions of Litas. (The Lita is the Lithuanian currency. For this example use the exchange rate you compute, not the actual exchange rate). Government spending is projected to rise by 50 percent due to construction of the high-speed rail network
This is the status quo scenario
Total Output is equal to 5,000
Government spending is equal to 1,000
Tax revenue is equal to 1,000
Consumption is equal to 250+0.75*(Y-T);
The level of investment is 1,000-50r;
Net Exports are 500-500?,
the world real interest rate is five percent Assume that there are three political parties in Lithuania and each think that building the high speed rail network will have different effects on the economy. They have hired you as a consultant (moonlighting from your investment firm) to do an analysis showing what happens if their beliefs end up being true
a. THE LIBERAL PARTY believes that increasing government spending to build the high speed rail network will increase both G and GDP. That is G, will increase to 1,500 and GDP will increase by 500 too. Compare what happens to the economy (relative to the status quo) if the Liberal party is correct. How do private savings, public savings, national savings, investment, net exports, and the exchange rate change from the status quo?
b. THE CONSERVATIVE PARTY believes that building a high speed rail network will put people to work (thus increasing G), but that it will ultimately be useless (there will be no overall wealth created), so GDP will be unchanged. The conservatives are also concerned that the government taking on new debt will be a bad sign to Lithuania’s creditors, and that borrowing the money for the high-speed rail system will cause the interest rate to rise 20 percent. Under this scenario, how do private savings, public savings, national savings, investment, net exports, and the exchange rate change from the status quo?
c. THE LIBERTARIAN PARTY believes that taking tax money and using it to build a high-speed rail network does nothing more than take money from one group of people (taxpayers) and give it to another group of people (the construction industry) and that there is no productive economic impact. How do private savings, public savings, national savings, Net exports, and the exchange rate change from the status quo?
d. Please compare situations a, b, and c. Who do you think is correct, and why?
e. The Libertarians use a microeconomics explanation about taxation to argue that the economy will be helped most by simply reducing taxes, even if people only save the money that they don’t spend on taxes (C is not affected). They say that this phenomenon is assumed away by most macro-economists. What are they referring to?