Question

(a) Consider the US loanable funds market. For each of the following separate scenarios, draw a graph to show how the equilibrium interest rate and equilibrium quantity of loanable funds changes. (i) Banks impose more regulations and make it more difficult for firms to borrow. (ii) Productivity of machines decreases. (iii) Households are less confident about the economy, they expect a recession will come soon. (b) If households expect a recession will come soon, will this increase the natural rate of unemployment? Explain. (c) A recession really occurs, but unemployment rate decreases. Explain how this can be possible. (d) The government makes it more difficult for companies to lay off their workers. However, unemployment rate increases as a result. Explain.

Answer 1

(Question a)

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

(i)

If borrowing becomes difficult, firms borrow less, which decreases investment. Lower investment decreases the demand for loanable funds. Demand curve shifts leftward, decreasing interest rate and decreasing quantity of lanable funds.

In following graph, decrease in demand shifts D0 leftward to D1, intersecting S0 at point B with lower interest rate r1 and lower quantity of loanable funds Q1.

(ii)

Lower productivity reduces firms' profitability, hence they decrease investment. Lower investment decreases the demand for loanable funds. Demand curve shifts leftward, decreasing interest rate and decreasing quantity of lanable funds.

In following graph, decrease in demand shifts D0 leftward to D1, intersecting S0 at point B with lower interest rate r1 and lower quantity of loanable funds Q1.

(iii)

When households anticipate a recession, consumer confidence decreases, so they reduce consumption and increase savings. This increases the supply of loanable funds. Supply curve shifts rightward, decreasing interest rate and increasing quantity of lanable funds.

In following graph, increase in supply shifts S0 rightward to S1, intersecting D0 at point B with lower interest rate r1 and higher quantity of loanable funds Q1.

NOTE: As HOMEWORKLIB's Policy, only the 1st part with multiple sub-parts can be answered. You need to post other questions separately.