Question

At the interest rate of 5%, the people of the country of Rupertopia are willing to lend $10,000 to local business, while local businesses are willing to borrow $20,000. When the interest rate rises to 10%, the quantity of loans supplied increases to $20,000, while the quantity of loans demanded drops to $10,000. Because the people of Rupertopia are suspicious of outsiders, all financial transactions happen between locals. Assume both supply and demand curves for loanable funds are linear.

Suppose the town council of Rupertopia, instead of running their usual balanced budget, decides to borrow $5,000 from the townspeople to build a new park. Assume the supply of loanable funds stays constant. Given this information and holding everything else constant, which of the following statements is true:

I. The equilibrium level of private investment spending in Rupertopia will decrease

II. The equilibrium level of savings in Rupertopia will increase

III. The equilibrium interest rate will increase after the town council implements the decision.

Select one:

a. Only I. and III are true

b.  I. II. and III. are all true

c. Only II. and III. are true

d. Only I. is true

Answer 1

The Town Council can borrow money from the public by selling its bonds to them. To ensure that people buy the bonds, the council needs to reduce the price of the bonds while increasing their yields (interest rate). So, when the council borrows money from the public two things happen.

1. Amount of loanable funds available for private investment declines due to crowding out.
2. Interest rate rises.

Because of the above two events the equilibrium level of private investment spending in Rupertopia will decrease, the equilibrium level of savings in Rupertopia will increase, and the equilibrium interest rate will increase after the town council implements the decision.

So, all the three statements are correct.