Question

5. The market for loanable funds and government policy The following graph shows the market for loanable funds. For each of the given scenarios, adjust the appropriate curve on the graph to help you complete the questions that follow. Treat each scenario separately by resetting the graph to its original state before examining the effect of each Individual scenario. (Note: You will not be graded on any changes you make to the graph.) INTERESTREP LOANASLE PUNOS 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 an increase in the maximum contribution, from $5,000 to $8,000 per year. Shift the appropriate curve on the graph to reflect this change This change in the tax treatment of saving causes the equilibrium interest rate in the market for loanable funds to and the 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 saving to and the level of Scenario 3: Initially, the government's budget is balanced; then the government responds to the conclusion of a war by significantly reducing defense spending without changing taxes. This change in spending causes the government to run a budget national saving which Shift the appropriate curve on the graph to reflect this change. This causes the interest rate to the level of investment spending.

Answer 1

D0 and S0 denote initial demand and supply curves of loanable funds while D1 and S1 denote the new curves. R0 and Q0 are initial rate of interest and quantity of loanable funds while R1 and Q1 are new ones.

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1. This change in the tax treatment of interest income from saving causes the equilibrium interest rate in the market for loanable funds to fall and the level of investment spending to increase.

This happens so since a greater level of people's income is now sheltered from taxes. Thus the supply of loanable curve shifts right due to higher savings. As lenders lower their interest rates to attract borrowers, the quantity of loanable funds demanded increases. The equilibrium interest rate falls, and the equilibrium quantity of loanable funds saved and invested rises.

2. The repeal of the previously existing tax credit causes the interest rate to fall and the level of saving to fall.

As the governent repeals previously existing tax credit, it acts as a disincentive to borrow funds. The demand for loanable funds shift leftwards. At the new lower interest rate, lenders supply lesser quantity of loanable funds.

3. This change in spending causes the government to run a budget surplus, which increases national saving.

This causes the interest rate to fall, increasing the level of investment spending.

The government moves from a budget balance to a budget surplus when it reduces government spending without changing taxes. This increase in public saving causes national saving to rise. Since saving is the source of supply in the market for loanable funds, the increase in public saving causes the supply of loanable funds to shift to the right. The result is a surplus of loanable funds at the initial interest rate. As lenders lower their interest rates to attract borrowers, the quantity of loanable funds demanded increases. The equilibrium interest rate falls, and the equilibrium quantity of loanable funds saved and invested rises.