Question

Suppose the supply of loanable funds is fixed by policy. Explain what happens to the demand...

Suppose the supply of loanable funds is fixed by policy. Explain what happens to the demand for loanable funds, investment, the equilibrium quantity of loanable funds and the equilibrium interest rates, when the government removes investment tax credit (please explain your answer in details using diagrams!!)

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Answer #1

When supply of loanable funds is fixed, equilibrium quantity of loanable funds is fixed, and only the interest rate will vary with change in demand for loanable funds.

When government removes investment tax credit, firms will decrease investment. Lower investment will decrease the demand for loanable funds, shifting the demand curve for loanable funds leftward, which will decrease equilibrium interest rate.

In following graph, interest rate (r) and quantity of loanable funds (Q) are measured vertically & horizontally respectively. D0 and S0 are initial demand & supply curves for loanable funds (with vertical supply curve), intersecting at point A with initial interest rate r0 and quantity of loanable funds Q0. As demand falls, D0 shifts leftward to D1, intersecting S0 at point B with lower interest rate r1 and same quantity of loanable funds Q0.

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