Question

 5. The market for loanable funds and government policy

 The following graph shows the market for loanable funds. For each of the given scenarios, adjust the appropriate curve on the graph to help you complete the questions that follow. Treat each scenario separately by resetting the graph to its original state before examining the effect of each individual scenario. (Note: You will not be graded on any changes you make to the graph.)

 Scenario 1: Individual Retirement Accounts (IRAs) allow people to shelter some of their income from taxation. Suppose the maximum annual contribution to such accounts is $5,000 per person. Now suppose there is an increase in the maximum contribution, from $5,000 to $8,000 per year.

 Shift the appropriate curve on the graph to reflect this change.

 This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to _______  and the level of investment spending to _______ .

 Scenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the government implements a new investment tax credit.

 Shift the appropriate curve on the graph to reflect this change.

 The implementation of the new tax credit causes the interest rate to _______  and the level of saving to _______ .

 Scenario 3: Initially, the government's budget is balanced; then the government significantly increases spending on national defense without changing taxes.

 This change in spending causes the government to run a budget _______ , which _______  national saving.

 Shift the appropriate curve on the graph to reflect this change.

 This causes the interest rate to _______ , _______ the level of investment spending.

Answer 1

Scenario 1

(a) Increase in IRA contribution will increase savings, thus increasing the supply of loanable funds, shifting the supply curve of loanable funds rightward.

(b) This change causes equilibrium interest rate to Decrease and level of investment spending to Increase.

Scenario 2

(a) New tax credit will increase business investment, shifting demand for loanable funds rightward.

(b) New existing investment tax credit causes interest rate to Increase and level of saving to Increase.

Scenario 3

(a) Increase in government spending increases the demand for loanable funds, shifting demand curve for loanable funds rightward.

(b) This causes government to run a Budget Deficit which decreases national saving.

(b) This causes interest rate to increase, crowding out investment spending.