Question

Assume that the market for loanble funds is in equilibrium and that the federal government budget is balanced. Now assume that the federal government begins to run a budget deficit (G > T). Does this shift the supply or demand for loanable funds? Why? What happens to the real interest rate? What happens to the quantity of loanable funds? What is the resulting impact on investment in the economy? What is this called?

Answer 1

If there is a deficit in the government budget ie the government expenditure is more than the taxes and other revenue, then it would lead to an increase in demand of loans. This is because now the government would also need to borrow money like the private individuals.

This would increase the demand for loanable funds or a reduction in supply of loanable funds. When the government has a budget deficit it would mean that it is not able to save. This would reduce the savings of the economy, so supply would shift to left.

This would mean an increase in the interest rate. the government's savings or national savings have reduced, the quantity of loanable funds would reduce.

The investments in the economy would also reduce. This is known as crowding out ie when the government competes with private sector for loans which are scarcely available. This would reduce private investment and increase interest rate because of government borrowings.