Question

In terms of the loanable funds market, what happen to consumption, the interest rate, and investment when the government increases taxes?

Answer 1

When government increases taxes then the personal disposable income(Y-T) of people is reduced. This leads to two things first a fall in consumption which is a function of disposable income. Second a reduction in private savings. (Given that income is unchanged). As private savings falls there is also a fall in national savings (NS = pvt saving + public saving). So the supply of lonable funds which is national savings -decreases. So supply curve shifts left from S0 to S1. This shifts equilibrium to e1 where interest rate is higher at r1. While quantity of lonable funds fall along the demand for lonable funds curve D (which represents investment demand). So investment falls and equilibrium quantity falls to Q1. The effect is demonstrated in the graph below -