Question

Suppose the government creates an investment incentive, such as a tax credit for undertaking capital improvements.

a.     Show how the market for loanable funds is affected in a (well-labeled) graph (6 points).

b.     Explain how the equilibrium “price” and quantity have changed in this market (2 points).

Answer 1

a)

In the figure above, D is the demand for loanable funds i.e. investment demand and S is the supply of loanable funds i.e. savings in the economy. As the government provides tax credit, the cost of borrowings decreases and thus the demand for investment rises and the demand for loanable funds increase from D to D' (as shown in the figure above).

b) The demand for loanable funds rise from D to D'. At new equilibrium, the equilibrium rate of interest rises to r1 and the equilibrium quantity to Q1.

Thanks!