Question

Using the model of loanable funds developed in Chapter 3, explain how the following changes affect the real interest rate, investment, consumption, and government expenditure. Include the appropriate diagram as part of your answer in each case. Initially assume that consumption depends only on disposable income. (a) The government increases taxes. (b) Expectations about the future profitability of investment improve. (Hint: For a given real interest rate, r, firms will invest a greater amount after expectations improve). (c) How does your answer to (b) change if consumption also depends on the real interest rate (i.e. is decreasing with r)?

Answer 1

In following graphs, D0 and S0 are initial demand and supply curves of loanable funds, intersecting at point A with initial interest rate r0 and quantity of loanable funds (saving and investment) Q0.

(a)

Higher tax decreases income, so people decrease consumption and also save less. Lower saving shifts supply curve leftward, increasing interest rate and decreasing quantity of loanable funds (saving and investment). This does not immediately change government spending.

In following graph, S0 shifts left to S1, intersecting D0 at point B with higher interest rate r1 and lower quantity of loanable funds (savings and investment) Q1.

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(b)

Enhanced expectation about future profitability causes firms to investment more. As investment increases, demand for loanable funds increases, shifting demand curve rightward, increasing interest rate and increasing quantity of loanable funds (saving and investment). This does not immediately change consumption or government spending.

In following graph, D0 shifts right to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of loanable funds (savings and investment) Q1.

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(c) If consumption also depends on interest rate in a negative relationship, then higher interest rate caused by higher investment will decrease consumption and increase savings. As a result, supply curve will shift rightward (at the same time), decreasing interest rate and increasing quantity of loanable funds. The net effect is a definite increase in quantity of loanable funds but net effect on interest rate is uncertain. This does not immediately change government spending.

In following graph, D0 shifts right to D1 and S0 shifts right to S1, intersecting at point B with higher quantity of loanable funds (savings and investment) Q1 and new interest rate r1.

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