Question

Use the model of the market for loanable funds to predict the effects of the following events:

a) A tax credit is given to firms starting a new business or expanding a current business.

b) An unhealthy economy has depressed firms future profit expectations.

c) The federal government goes from a balanced budget to a budget surplus.

Answer 1

In each graph, interest rate (P) and quantity of loanable funds (Q) are measured vertically and horizontally respectively. D0 & S0 are initial demand & supply for loanable funds, intersecting at point A with initial interest rate P0 and quantity of loanable funds Q0.

(a) A tax credit will increase business investment, increasing demand for loanable funds. Demand curve will shift rightward, increasing both interest rate and quantity of loanable funds. In following graph, D0 shifts right to D1, intersecting S0 at point B with higher interest rate P1 and higher quantity of loanable funds Q1.

(b) Pessimistic business outlook will decrease business investment, decreasing demand for loanable funds. Demand curve will shift leftward, decreasing both interest rate and quantity of loanable funds. In following graph, D0 shifts left to D1, intersecting S0 at point B with lower interest rate P1 and lower quantity of loanable funds Q1.

(c) A budget surplus reduces the need for government's definit financing, thereby lowering the demand for loanable funds. Demand curve will shift leftward, decreasing both interest rate and quantity of loanable funds. In following graph, D0 shifts left to D1, intersecting S0 at point B with lower interest rate P1 and lower quantity of loanable funds Q1.