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Part 1 - Use the loanable funds market to graphically show how real interest rate (r),...

Part 1 - Use the loanable funds market to graphically show how real interest rate (r), saving (S) and investment (I) would change when the goverment increase the tax rate on interest income. Explain in detail.

Part 2 - Use the loanable funds market to graphically show how real interest rate (r), saving (S) and investment (I) would change when the goverment cut the tax rate on corporate prot. Explain in detail.

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Answer #1

In each graph, 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/Investment) Q0.

(Part 1)

Increase in tax rate on interest income will discourage savings. A decrease in savings will reduce supply of loanable funds, shifting supply curve leftward, raising interest rate and decreasing quantity of loanable funds (savings and investment).

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.

(Part 2)

Lower tax rate on corporate profit will encourage firms to increase investment. Higher investment will increase the demand of loanable funds, shifting demand curve rightward, increasing interest rate and increasing quantity of loanable funds (savings and investment).

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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