Question

Which of the following events would most likely explain a general increase in interest rates and a decrease in private investment in the loanable funds model, ceteris paribus?

A. The U.S. federal government generates a surplus of $1 trillion and uses it to pay down the national debt.

B. The U.S. federal government budget goes from deficit to surplus.

C. The U.S. federal government reduces the tax rate on savings.

D. The U.S. federal government budget deficit increases.

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2. Suppose the U.S. Congress passed, and the president signed, legislation that encouraged U.S. taxpayers to consume more and save less, by lowering the excise tax on various goods. As a likely consequence of this legislation, the loanable funds model would predict, ceteris paribus:

A. higher interest rates and less investment.

B. lower interest rates and greater investment.

C. lower interest rates and less investment.

D. higher interest rates and higher investment.

Answer 1

a) Ans. Option D

Explanation: We know that for loanable funds equilibrium,

Supply of Loanable funds = Demand for Loanable funds

=> Savings by household and government sector = Investment

=> S = I

Now, we know Y = C + I + G [From IS equilibrium, where C= Consumption, I= Investment, G= Govt. Expenditure]

So, I = Y – C – G

Or, I = (Y – T – C) + (T – G)… [ T = Tax collected by the govt ]… Equation 1

Or, Investment = Household savings + Budget Surplus

Now, if budget deficit increases, it implies a fall in budget surplus.

So, the right hand side of the equation decreases.

To maintain the equilibrium, Investment decreases with the increase of rate of interest as we all know that investment is a falling function of rate of interest.

b) Option A

From Equation 1 of the above explanation, if household savings decreases, (Y – T – C) decreases.

To keep the equilibrium, rate of interest will increase so that investment decreases.

Please refer to picture attached with the solution, the equilibrium will shift from E to F in both the cases as savings curve will shift leftward due to a decrease in budget surplus (in case of (a)) and due to a decrease in household savings (in case of (b)). To maintain the equilibrium rate of interest will increase from r₀ to r₁.