Question

Q.1 (15 points) Assume that the equilibrium in the loanable funds market is at an interest rate of 5% and the total quantity of loans is $650 billion. In addition, in this initial situation, the government is borrowing $80 billion per year to fund the budget deficit. (a) How much is the private investment in this initial equilibrium? (b) Now the government increases spending by $320 billion per year and finances this spending completely with additional borrowing. (i) Draw a graph to show how the additional borrowing would change the market for loanable funds. (ii) How much is the total government borrowing after the additional borrowing? (iii) Assume that the new equilibrium quantity of loans is at $800 billion and assume complete crowding-out. Determine the amount that each component of GDP changes, assuming no change in net exports. (c) Explain why foreigners putting more money in the domestic loanable funds market can help reduce the crowding out effects.

Answer 1

Supply 5% Demand $6506 Loanable funds Government Borrowing Loamalt Private Investment + supply of Private Investment $650 80 billion $570 billion $320b b) Now the government increases its borrowing by 5%. 16320 Now Demand Old Demand Loanable Funde $650b interest rates increase this spurt of government borrow which depresses private borrowing is $320 880 1) Total government borrowing Now equilibrium quantity of loans is Government borrowing $ 400b $80

Interest increase $40 400 bila $320 by this spurt of govern which depresses private borrowing 11) Total government borrowing equilibrium quantity of Government borr orrowing Private $400 6 loans in $800 billion New $ 400 6 investment Investment ch changes by Government spending Increase in supply $ 400 billion changes by $400 billion supply of loanable funds leads to a interest rates increase and investment decrease in