Question

Suppose the Australian government has announced tax cuts for the business sector. Using the loanable funds model, explain how this will impact the supply of and demand for loanable funds and the interest rate in Australia. (Explain your answer using diagrams).  

Answer 1

Let us consider an initial situation where the tax cuts for the business sector have not yet been announced.

As we can see in the above graph, the equilibrium in the market is at interest rate ( i₁ ) and quantity of funds ( Q₁ )

Now, consider a situation where the government announces tax cuts for the business sector. A cut in the tax rate for the business sector increases the in hand cash amount for businesses. The businesses would now be incentivized to invest more in their business as the cost of doing business has come down due to the tax cuts. Some investments, which earlier would have been unprofitable because of the higher tax rate might now turn profitable. This will increase the demand for loanable funds as businesses would need more capital for investments. This means that for the same rate of interest, there would be more demand for funds than earlier. This is represented by a right ward shift in the demand for loanable funds graph.

As we can now see from the above graph, the demand curve has shifted right ward to D₂ from D₁. This implies that the demand for loanable funds has increased after the tax cuts. At the new equilibrium, the interest rate is i₂ and the equilibrium quantity of loanable funds is Q₂. We can see that there is an increase in the interest rates and the quantity of loanable funds in the market. ( i₂ > i₁ ; Q₂ > Q₁ )