Economists state that currently debated financial reform legislation has two possible effects: (1) stringent regulations increase...

Economists state that currently debated financial reform legislation has two possible effects: (1) stringent regulations increase the costs of investment, and (2) effective regulation increases savers’ confidence in the financial system.

(a) Suppose that, by requiring firms to comply with strict regulations, financial reform legislation increases the costs of investment. Using a diagram of the market for loanable funds, show the consequences of this legislation in this case. What happens to the equilibrium interest rate and level of saving and investment? What are the likely effects of this on living standards over time?

(b) Suppose, on the other hand, that by effectively regulating the financial system, financial reform legislation increases savers’ confidence in the financial system. Using a second diagram of the market for loanable funds, show the consequences of this legislation in this alternative scenario. What happens to the equilibrium interest rate and level of saving and investment in this case? What are the likely effects of this on living standards over time?

Solutions

Expert Solution

When the cost of investment increases, people will be discouraged to borrow funds to invest. As a result, the demand for loanable funds will decline and the demand curve shifts downwards to the left as shown in the diagram.

Equilibrium rate of interest falls from r to r1 and the equilibrium quantity of loanable funds saved and invested falls from L to L1. This will affect the longterm growth of the country which will further affect the living standards of the people in the long run.

(b)

If it encourages the saver's confidence in the financial market, the supply of loanable funds will increase in the market. As a result, the supply curve shifts to the right from S o S1.

Equilibrium rate of interest reduces from r to r1.

The equilibrium quantity of loanable funds saved and invested increases from L to L1. This will lead to higher economic growth in the long term which will further lead to increased living standards of the people.

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Rahul Sunny answered 2 years ago

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