Question

Does each of the following affect either the supply or the demand for loanable funds, and if so, does the affected curve increase (shift to the right) or decrease (shift to the left)? What’s the effect on the equilibrium interest rate and equilibrium quantity of loanable funds? (Please present your answer graphically.)

(1) The Federal government reduces the tax of corporate profit.

(2) Crowding out

Answer 1

ANS (a) -. EFFECT OF FALL IN CORPORATE PROFIT TAX -

In loanable funds demand for loans is made by borrowers , which is inversely related to interest rate . And if the corporate profit tax falls , their the demand for loanable funds will decrease , because the firms will be able to invest more from the savings made from fall in profit tax and can increase there investment from rise in retained earnings or profits earned and the demand for loans will decrease. Hence,the demand for loans from loanable funds market will fall and demand curve will shift leftwards from DD' to DD1 and new equilibrium is formed at E1 where it intersect with supply curve and interest rate will fall (as shown in figure 1 ) . and equilibrium quantity of loanable funds will fall from Qo to Q1.

ANS (b) GROWING OUT - When there is crowding out then the government will use expansionary fiscal Policy like Increase in government spending, and in order to meet it's expenditure it will borrow from loanable funds market. As a result the demand for loans will rise and the demand curve of loanable funds will shift rightwards and new equilibrium is formed at E1 where new demand curve intersect with supply curve . Hence , interest rate rises and equilibrium quantity of loanable funds will also rises.( As shown in figure 2)