Question

Given a closed economy in the long run (classical model):

Y=F(K,L)

Y=C+I+G C=c(Y-T)

I=I(r)

G and T set by Government policy.

For the following changes in the economy, show the impact of the change on the loanable fund market. Use a fully labeled graph.

Also state the impact of the change on the following variables: Y, C, G, S, I and r.

1) A decrease in Government Spending.

2) A decrease in Taxes.

3) An increase in Investment demand.

Answer 1

In each graph, D0 and S0 are initial demand and supply curves of loanable funds, intersecting at point A with initial interest rate r0 and quantity of loanable funds (savings and investment) Q0.

(1)

Decrease in government spending lowers budget deficit, so government borrowing decreases. This decreases the demand for loanable funds, shifting demand curve leftward, decreasing interest rate and decreasing quantity of loanable funds (thus reducing both savings and investment). Lower income decreases consumption demand as well.

In following graph, D0 shifts left to D1, intersecting S0 at point B with lower interest rate r1 and lower quantity of loanable funds (savings and investment) Q1.

(2)

When tax decreases, disposable income increases, so people consume more which decreases savings. As savings fall, supply of loanable funds decreases, shifting supply curve leftward, increasing interest rate and decreasing quantity of loanable funds (savings and investment). Lower income decreases consumption demand as well.

In following graph, S0 shifts left to S1, intersecting D0 at point B with higher interest rate r1 and lower quantity of loanable funds (savings and investment) Q1.

(3)

Increase in investment demand increases the demand for loanable funds, shifting demand curve rightward, increasing interest rate and increasing quantity of loanable funds (thus increasing both savings and investment). This leads to higher income, which increases consumption demand as well.

In following graph, D0 shifts right to D1, intersecting S0 at point B with higher interest rate r1 and higher quantity of loanable funds (savings and investment) Q1.