Question

Suppose in Year 1 a country had a balanced government budget, while in Year 2, the country has a $200 billion government budget deficit. In Year 1, the private sector quantity of loanable funds exchanged was $700 billion. All else equal, in Year 2 the quantity of loanable funds exchanged in the private sector might be,

	a.	$800 billion
	b.	$700 billion
	c.	$600 billion
	d.	$500 billion
	e.	$400 billion

Answer 1

Answer depends upon crowding out effect which is the reduction in private investment whenever government borrowing increases. In this case there was no deficit in first year but in the second year there is a deficit which implies that the government might borrow from the loanable funds market. Which will decrease the quantity of funds available for private investment. The reduction will not be entirely by 200 billion because supply and demand functions in the loanable funds market are fairly elastic. But it will be reduced by a value which is less than 200 billion.

Select C.