Question

a. When funded by borrowing, what effect will expansionary fiscal policy have on the loanable funds market?

• An increase in the supply of loanable funds

• An increase in the demand for loanable funds

• A decrease in the supply of loanable funds

• A decrease in demand for loanable funds

b.

If a fiscal policy action causes "crowding out," what would most likely be the result?

Decreased gross investment

• Decreased net exports

• Increased net exports

• Increased consumer expenditures

c.True or false: Changes to government purchases, but not taxation, cause "crowding out" to occur.

Answer 1

Soln (a):

Due to increase in funding by borrowing by the government as a expansionary fiscal policy there would be a increase in the demand for loanable funds in the market. This is because due to increased borrowing the expansionary fiscal policy increases the deficit. As a result of this to maintain equilibrium the government must borrow more and increase its debt. This in turn inceases the interest rate on loanable funds and crowding of private investment occurs. This shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. Due to high interest rates the demand for loanable funds increases as A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption.

Soln (b):

If an expansionary fiscal policy causes Crowding out effect in the economy the result is decreased gross investment in private sector. This is because of increased government borrowing creates a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment.

Soln (c):

Ans- False ( both changes in governmemt purchases and taxation causes crowding out effect)