| This question requires you to link together the market
for savings and investment with the production, or supply, side. We have
seen in the answer to question 2
that an increase in the capital stock shifts the marginal product curve
for labor upwards. It then follows that employment must rise (draw the
effect of an increase in the capital stock in the labor market supply-demand
diagram). Having now established that both the capital stock and
employment has risen, there can be no doubt that total output also rises. |
| We now turn to the savings-investment diagram. What happens
to private savings if there is an increase in output? Output and income
are one and the same thing, so income has risen. Intuitively, we expect
that people will save more when income is higher, so the saving curve must
shift to the right. But, if the saving curve shifts to the right, then
the real rate of interest must be lower to induce firms to invest more.
That is, an increase in the capital stock must cause a reduction in the
real rate of interest. |
| Moving beyond the question itself, note that there is
a nice symmetrry in the relationship between the capital stock and the
real interest rate. If the capital stock rises, the real interest rate
falls. But one could also ask the following question: if the real interest
rate falls, what happens to the capital stock? The answer depends on why
the interest rate fell. Imagine that people start saving more (a rightward
shift of the saving curve). Then investment must increase. But if investment
increases, the capital stock rises. |