Question

Suppose the government reduces taxes but holds government spending constant, thus increasing the government budget deficit....

Suppose the government reduces taxes but holds government spending constant, thus increasing the government budget deficit.

1. What would be the major effect in the market for loanable funds?

                  Increase in demand for loanable funds (increased supply of bonds)               

                  Decrease in demand for loanable funds (decreased supply of bonds)

                  Increase in supply of loanable funds (increased demand for bonds)

                  Decrease in supply of federal funds (decreased demand for bonds)

Why?

2. Graphically illustrate the effect on the equilibrium interest rate and quantity of loanable funds.

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Answer #1

Government budget deficit impacts the funds in loanable funds market where it may need to finance the increased deficit. When this happens boorowings are increased and hence demand for funds increases. Correct choice is  Increase in demand for loanable funds (increased supply of bonds)

This shift raises the interest rate because the supply of funds that comes from bonds market is increased only when rate of interest is higher. Equilibrium quantity of funds traded also rises

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