Question

Supply Demand Supply INTEREST RATE (Percent) Demand LOANABLE FUNDS (Billions of dollars) Scenario 1: Individual Retirement Accounts (IRAS) allow people to shelter some of their income from taxation. Suppose the maximum annual contribution to such accounts is $5,000 per person. Now suppose there is a decrease in the maximum contribution, from $5,000 to $3,000 per year. Shift the appropriate curve on the graph to reflect this change. and the This change in the tax treatment of interest income from saving causes the equilibrium interest rate in the market for loanable funds to level of investment spending to Scenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the government repeals a previously existing investment tax credit. Shift the appropriate curve on the graph to reflect this change. The repeal of the previously existing tax credit causes the interest rate to and the level of investment to : Scenario 3: Initially, the government's budget is balanced; then the government significantly increases spending on national defense without changing taxes. This change in spending causes the government to run a budget , which national saving. Shift the appropriate curve on the graph to reflect this change. This causes the interest rate to , the level of investment spending.

Answer 1

1) This change in the tax treatment of interest income from saving causes the equilibrium interest rate in the market for loanable funds to rise and the level of investment spending to decrease. (supply shifts left)

Interest rate Loanable funds

2) The repeal of the previously existing tax credit causes the interest rate to fall and the level of investment to rise (inverse relationship)

Demand shifts left

Interest rate Loanable funds

3) Demand for loans would increase (Right shift)

This change in spending causes the government to run a budget deficit, which decreases national saving. (Government saving decreases as spending increases)

This causes the interest rate to rise, decreasing the level of investment spending.

Interest rate Loanable funds