Question

Consider equilibrium in the loanable funds market with savings and investment equal to $150 million. The government increases its spending by $100 million and finances the deficit through borrowing in the loanable funds market. If the equilibrium quantity of loanable funds increases to $170 million, assuming complete crowding out, consumption must fall by __________ and the new level of investment must be _________.

A) $20 million; $170 million

B) $20 million; $70 million

C) $20 million; $80 million

D) $50 million; $100 million

Answer 1

Solution: $20 million; $70 million

Explanation: With a rise in government spending, the equilibrium level of loanable funds would rose from $150 million to $170 million. Therefore $20 million (= $170 – $150) would goes to the government for financing the $100 million rise in spending. Now the $20 million comes with a rise in savings that must cause consumption to decline with $20 million. The other $80 million borrowed will cause a fall in the private investment by $80 million. Thus, the new level of private investment will equal $70 million (= $150 - $80)