Question

Using the loanable funds theory, show in a graph how each
of the following events affects the supply and demand for loans and the
equilibrium real interest rate:

a). A war leads the government to increase spending on the military.
(Assume taxes do not change.). Please note, to get full points, you need to
illustrate (on the proper, well-labeled graph) and explain.
b). Wars in other countries lead to higher government spending in
those countries. Please note, to get full points, you need to illustrate (on the
proper, well-labeled graph) and explain.
c). Someone invents a new kind of computer that makes firms more
productive. Many firms want to buy the computer. Higher productivity also
increases people’s confidence in the economy, so consumers see less need to save.
Please note, to get full points, you need to illustrate (on the proper, well-labeled
graph) and explain.
d). The same things happen as in part (c). In addition, increased
confidence in the economy raises net capital inflows. Please note, to get full points,
you need to illustrate (on the proper, well-labeled graph) and explain.

Answer 1

Suppose initially a loanable market is equilibrium at point E where demand curve for loanable funds and supply curve of loanable funds intersects at r level of interest rate and Q level quantity of loanable funds
a. A war leads the government to increase spending on military (assume taxes do not change ). Higher government spending on military leads to demand for loanable funds.
It will shift the demand curve rightward. It will increase the rate of interest to r1 and quantity of loanable funds to Q1
b. Wars in other countries leads to higher government spending in those countries. It will create an pessimism due to uncertain future condition in domestic economy. It will increase the supply of loanable funds ( saving). It will shift the supply curve of loanable funds to rights. It will make loanable funds remain same and rate of interest will rise to r1
c. If someone invents a new kind of computer that makes firms more productive. It increases the people's confidence in the economy.Many firms want to buy the computer. It will increase the demand for loanable funds. As a result demand curve shifts rightward and quantity of loanable funds increases to Q1 and supply curve shifts left. Therefore rate of
interest remain constant
d. Due to higher productivity, confidence in the economy raises net capital inflows. It will increase the demand for loanable funds in domestic economy. It shifts demand curve into rightward and supply curve into leftward. It will make the quantity of loanable funds same and rate of interest will rise to r1