1.Suppose that the federal government has a budget deficit and the economy is closed. Using the...

1.Suppose that the federal government has a budget deficit and the economy is closed. Using the savings–investment spending identity, explain how this affects investment spending.

2.The market for loanable funds is in equilibrium. All else equal, the federal government has eliminated taxes on interest earned from savings. Describe how this will affect the market for loanable funds, the equilibrium interest rate, and the equilibrium quantity of loanable funds.

Expert Solution

(1)

A budget deficit increases government borrowing for deficit financing. Since investment represents the demand for borrowing, higher borrowing increases investment, shifting investment curve to right, increasing interest rate and equilibrium investment (and savings).

In following graph, I0 and S0 are initial investment and saving curves, intersecting at point A with initial interest rate r0 and equilibrium investment & savings Q0. Higher investment shifts I0 right to I1, intersecting s0 at point B with higher interest rate r1 and higher investment & savings Q1.

(2)

Zero tax on interest income will incraese savings, shifting supply curve of loanable funds rightward, decreasing interest rate and increasing quantity of loanable funds.

In following graph, D0 and S0 are initial demand and supply curves for loanable funds, intersecting at point A with initial interest rate r0 and quantity of loanable funds Q0. Higher savings shifts S0 right to S1, intersecting D0 at point B with lower interest rate r1 and higher quantity of loanable funds Q1.

Rahul Sunny answered 6 months ago

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1.Suppose that the federal government has a budget deficit and the economy is closed. Using the...

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