Question

5. The government is running a budget balance of zero when it decides to increase education spending by $200 billion and finance the spending by selling bonds. The accompanying diagram shows the market for loanable funds before the government sells the bonds. Assume that there are no capital inflows or outflows. How will the equilibrium interest rate and the equilibrium quantity of loanable funds change? Is there any crowding out in the market? Interest rate 24% 22 0 $200 400 600 800 1,000 1,200 Quantity of loanable funds (billions of dollars)

Answer 1

This will rise the interest rates which will cause the demand for loadable funds to fall, so demand curve will shift to the left. Equilibrium will be at a point where demand and supply are equal on the same supply curve.

Government has 0 balance budget so it will be in deficit that will raise the interest rates. Higher interest rates will reduce the investmet spending, this will lead to crowding out.