Question

1: Explain why an decrease in the government budget deficit could lead to an increase in invest- ment by firms.

2: Suppose that because of a rising price level, consumer starts carrying more of their wealth as cash, in order to carry out transactions, and thus are less willing to put their wealth into other assets -such as stocks or bonds. Depict the effect this will have on the market for loanable funds, and explain what will happen to both interest rates and investment.  

Answer 1

a) A decrease in govt. budget defecit will mean government will have to borrow less from the market. Hence, demand for lonable funds decreases, this in turn leads to a decrease in interest rates, which in turn makes projects viable for the firms and hence they increase their investment owing to availability of cheaper funds.

b) As a result of this the supply of lonable funds will decrease, which will lead to interest rates sky rocketing and hence investments will fall because the cost of investment is interest rate.