Question

4. Assume that the equilibrium in the loanable funds market is at interest rate of 1.25% and quantity of funds at $20 billion. Suppose the current government deficit is zero so government is not borrowing any money.

a) Suppose now government increases spending by $2 billion and finances it entirely by borrowing. This deficit increases equilibrium interest rate to 2% and equilibrium quantity of funds to $21.5. Show the changes on the graph.

b) What happens to private investment (I) and total savings as a result of increase in the government spending?

c) Assuming total crowding out, that is, no change in aggregate demand, by how much does consumption (C) change?

Answer 1

4. Given that at the current equilibrium in the loanable funds market, the interest rate is 1.25% and quantity of funds is $20 billion.

a) Now government increases spending by $2 billion and finances it entirely by borrowing. This deficit increases equilibrium interest rate from 1.25% to 2% and equilibrium quantity of funds from $20 billion to $21.5 billion. This is shown below as a rightward shift in the loanable funds market

Interest rate Supply curve SS 2.00 1.25 E D'D Demand curve DD Quantity of funds (billons of $) 20 21.5

b) Since there is an increase in the rate of interest, it is likely that there is a decline in private investment (I). However, total savings should increase because private savings are increased more than the decline in public savings.

c) Assuming total crowding out, public savings are reduced by 2 billion but total savings are increased by 1.25 billion. Hence private savings are increased by 1.25 - (-2) = 3.25 billion. This implies that consumption declines by 3.25 billion.