Question

Use the loanable funds model to analyze the effects of a government budget deficit: -Draw the diagram showing the initial equilibrium of the loanable fund market in the below perpendicular axis. 1 point -Determine which curve shifts when the government runs a budget deficit (explain), and draw the new curve on your diagram. I point -What happens to the equilibrium values of the interest rate and investment? Explain. 1 point -Determine the relationship between the crowding-out effect and investment, explain 1 point -Determine which curve shifts when the government runs a budget surplus and explain. 1 point

Answer 1

1.

INTEREST RATE Q1 QUANTITY OF LOANABLE FUNDS

D1 is the demand for loanable funds and S1 is the supply for loanable funds. The loanable funds market achieves equilibrium when demand equals supply. Equilibrium interest rate is R1 and equilibrium quantity is Q1.

2.

INTEREST RATE D2 Di Q1 Q2 QUANTITY OF LOANABLE FUNDS

An increase in budget deficit leads to an increase in demand for loanable funds. The demand curve shifts from D1 to D2

3. Increase in government budget deficit increases the demand for loanable funds. this leads to an increase in the cost of borrowing that is interest rate and increase in loanable funds.

4. Crowding out effect refers to the fall in private investment due to increase in government investment or expenditure. When there is crowding out effect , investment increases partially not fully. This is because an increase in government expenditure eventually raises interest rate which further reduces private investment.

5. When there is a budget surplus, the supply for loanable funds increases and the supply curve shifts outward. Increase in budget surplus means increase in the availability of funds to be loaned. This leads to a fall in interest rate and rise in loanable funds.