Question

Consider an economy in which the loanable funds market is initially in equilibrium. Represent this using...

Consider an economy in which the loanable funds market is initially in equilibrium. Represent this using the appropriate graphs.

a. Other things the same, if the government increases transfer payments to households, without raising taxes, then how does the equilibrium level of national saving, investment and interest rates change? Explain your answer and show the changes using the graph from part (a).

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Answer #1

If the Government Increases transfer payments without Increasing taxes then this policy would Increase the demand for loanable funds in the loanable funds market. At the existing equilibrium interest rate, there is Excess demand for loanable funds. This would lead to an increase in interest rate. Increase in interest rate leads to a Decrease in Investment. And since Government expenditure increases and taxes remain same, Public saving goes down. As a result, National Saving also goes down. Effect of Increase in Transfer Payments by Government without Increase in Taxes is shown in the Diagram below:

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