Question

ont giver mort spending derease Interest rate thent Suppose that the new Prime Minister acts to cut government spending and, by doing so, eliminate the current federal government budget deficit. 12. In the loanable funds market, in which direction does the relevant curve shift? The supply curve for loanable funds shifting to the right there are more funds supplied at any given interest rate. 13. Does the interest rate rise or fall as a result of this change in policy in the loanable market? The interest rate falls. 14. What happens to private investment as a result of this change in policy? As the interest rate falls, private investment rises (eg, households buy more new houses and firms buy more new capital equipment)

Explain Q 12
Why cant i answer that cut government spending decrease the demand.

Answer 1

12. The demand for loanable fund comes from borrowers and supply of loanable fund comes from savers. The savers are sensitive to the change in interest rate Ceteris paribus an increase in the rate of interest gives more incentive to the savers to save more. But at low rate of interest the savers are unwilling to save more. Likewise while other things remaining constant the borrowers are willing to borrow more at lower rate of interest and less at higher rate of interest. In short the supply of loanable fund is directly related to the rate of interest whereas the demand for loanable fund inversely related to the rate of interest Government is the lareest borrower in the loanable fund market. A decision of the government to cut spending reduces the demand for loanable fund, The demand curve shift to the left and rate of interest falls. Rate of interest Supply KEI Demand Demand Quantity МI М The reduction in the governmcnt spcnding shifts the demand curvc of loanable fund leftward to 'Demand 1'. This lowers the rate of interest to R1. Then the supply of saving decreases because as rate of interest falls less quantity of saving is generated. The market moves to new equilibrium at 'El' with low interest and less quantity of loanable fund is supplied which is equal to MI. The demand curve of loanable fund shifting to the left: there are less funds are supplied at the given lower interest rate 13. The interest rate falls as a result of this change in policy in the loanable fund market. Interest rate falls This is one situation in the loanable fund market. The second effect is the crowding in effect of the cut in government spending As the government cuts its spending, the rate of interest falls. The fall in rate of interest stimulate more investment in private sctor and GDP incrcasc. As the level of income increasc the saving incrcasc. As per Kcyncsian aggregate expenditure model MPC - 0<I. As income increase the marginal propensity to consume declines and marginal propensity to save increase. Again if the government is already in surplus, extra money is available for the government to lend out. Thus the increased income of the people and surplus money with the government creates

more loanable fund and the supply curve of loanable fund shift to the right and the rate of interest falls. In ccrain casc the government uses its surplus moncy for lending. Such an act will shift the supply curve of loanable fund to the right at a given interest rate and the rate of interest falls. 14. One of the components of the demand for loanable fund is the borrowing by the private investors. The lower interest rate increases the demand for loanable fund for private investment. The household use more borrowed funds to buy more new houses which increase the demand for investment. Again the returns from capital nvestment increase as the rate of interest falls. Thus more capital investment will take place in the economy