Question

The economies of China and India experienced very rapid growth. This increases their
citizens’ income and wealth. In turn, these citizens increase their savings in their country
and also in the United States.
@ When foreign savings enter the US loanable funds market, which curves if affected — supply
or demand? How is the curve affected?

@ Draw the graph of the US loanable funds market both before and after the increase in
foreign savings?

@ How does the change in foreign savings affect both investment and future output in the
US?

Please describe in detail.

Answer 1

What people save becomes the funds spared/available to be borrowed/loaned and are called loanable funds. Classic route is, we saving at bank and bank advancing it as laons to borrowers.

The demand and supply curve for loanable funds are downward and upward sloping respectively, just like typical demand and supply curve. At equilibrium of these curves we get the equilibrium rate of interest and the equilibrium quantity.

Now, when foreigners save in US loanable funds market, the supply of loanable funds increases and the supply curve shifts rightwards.

From the second graph it is clear that with an increased supply of loanable funds, the rate of intetest falls and the equilibrium quantity demanded will increase. This could be explained as: with decreased rate of interest the cost of investment decreases and people borrow more, hence we have the increased equilibrium quantity of loanable funds demanded!

So it is clear that the borrowings will increase. Thus, we can say increased foreign savings will increase the investment.

Also we have output as a function of investment. Higher the investment on fixed capital like infrastructure, greater is the future output. As what we spend as an investment pays in future's increased output.

[GDP= C+I+G+NX. That is, GDP of current year includes the investment made in this year along with comsumption, government spending and net exports. However, the investment on fixed capital will be a factor of production for years to come. So an investment made today and similar fixed capital accumulations attribute the increased future output.]