Question

what would happen in the market for loanable funds if households gain confidence and start spending and drawing down their savings. Show a graph as well

Answer 1

Question

It has been stated that households gain confidence and start spending and drawing down their savings.

Savings acts as a source of supplyl of loanable funds.

As households will draw down their savings, the level of savings in the economy will decrease.

This decrease in savings will decrease the supply of loanable funds.

Following figure shows the loanable funds market -

Initially, the market for loanable funds was in equilibrium at point E. The equilibrium real interest rate was r and the equilibrium quantity of loanable funds was Q.

Now, households has reduced their savings. This has resulted in a decrease in supply of loanable funds in the market for loanable funds.

The supply curve of loanable funds shifts to the left from S to S1.

The new equilibrium is attained at point E1. The new equilibrium real interest rate is r1 and the new equilibrium quantity of loanable funds is Q1.

Thus,

The equilibrium real interest rate rises and equilibrium quantity of loanable funds decreases in the market for loanable funds if households gain confidence and start spending and drawing down the savings.