Question

Answer this question in the context of the loanable funds market model. Your answers should consist of

properly labeled graphs for parts a-c. For simplicity, maintain the assumption that the supply of loanable

funds is independent of the real interest rate.

a.

(5pts) Show the effect of an increase an in the stock of technology.

b.

(5pts) Show the effect of a change in consumer preferences which result in them becoming more

impatient and myopic.

c.

(5pts) Show the effect of a deficit financed program which provides investment subsidies to

businesses. Be careful on this one.

Answer 1

Consider the loanable fund market in the following fig. here “DL” be the demand for loanable fund and “SL” be the supply of loanable fund and “E1” be the equilibrium, => the equilibrium rate of interest rate is given by, “r1”.

Now, as the “stock of technology” increases, => the demand for loanable fund will increase horizontally to “DL2”. So, given the supply the new equilibrium will establish at “E2”, the intersection of “DL2” and “SL”. So, we can see that as the technology increases, => investment increases, => the rate of interest rate also increases.

b).

Now, as the consumer preferences changes results they become more impatient, => they increase their consumption and reduce saving, => the national saving decreases implied the supply of loanable fund decreases and shift towards the left side to “SL2”.

So, at the new equilibrium “E2” is the intersection of “DL” and “SL2”. SO, as the consumers get impatient implied the rate of interest increases and “savings” and “investment” decreases.

c).

Now, an introduction of deficit financed program which provides investment subsidies to business will increase the investment implied the demand for loanable fund increases.

So, here the demand for loanable fund increases to “DL2” from “DL1” and supply remain same, => given the demand the equilibrium is “E2” the intersection of “SL” and “DL2”. So, at this new equilibrium the rate of interest increases and investment as well as savings both also increases.